To avoid financial crises, keep an eye on the black swan
April 23, 2007
By Mark Gilbert
A slump in Chinese stocks on February 27 triggered the worst week for US equities in more than four years and the biggest one-day jump in volatility ever - the financial equivalent of a butterfly's flapping wing in New Delhi causing a hurricane in North Carolina.
Nassim Nicholas Taleb argues, in The Black Swan: The Impact of the Highly Improbable, that we are dangerously blind to the possibility of unlikely events, and reluctant to accept their unpredictability when they do occur. It is a seductive thesis.
A black swan, in Taleb talk, is an incredibly improbable event with a colossal impact, be it 9/11 or the rise of Google. Our response to such events is to rationalise them, making them appear more predictable than they were, the author argues.
In short, we kid ourselves.
The global economy gives "the appearance of stability" even as it "creates devastating black swans", he says. "We have never before lived under the threat of a global collapse. The financial ecology is swelling into gigantic, incestuous, bureaucratic banks; when one falls, they all fall."
Taleb paints himself as a Renaissance man, as conversant in music and literature as he is in mathematics and finance. Abundant examples and playful turns of phrase make this a fascinating, challenging read.
His investment fund, Empirica Capital, made him rich enough to spend his time contemplating life from "dilapidated but elegant cafes in regular neighbourhoods as undiluted with persons of commerce as possible". Such arrogant splashes stain more pages than is necessary, but Taleb has a few claims to fame.
His 2001 book, Fooled by Randomness, has been published in 18 languages. In an April 2002 profile in the New Yorker magazine, Taleb outlined his theory that luck played a huge, unacknowledged role in success for traders and investors.
In his new book, Taleb says we are all guilty of confirmation bias, tending to look for things that corroborate what we believe to be true. We are also victims of the narrative fallacy, "our predilection for compact stories over raw truths".
A casino might look like a business where calculations of risk and probability determine success or failure. Yet, Taleb says, the MGM Mirage casino in Las Vegas "spent hundreds of millions of dollars on gambling theory and hi-tech surveillance, while the bulk of the risks came from outside their models".
Consider the white tiger that mauled magician Roy Horn at the Mirage in October 2003, costing it $100 million (R700 million), Taleb says. Or the disgruntled contractor who tried to dynamite the place. One employee failed to file tax returns on big-winning gamblers, resulting in "a monstrous fine", while the owner violated gambling laws to pay the ransom on his kidnapped daughter.
"The dollar value of these black swans, the off-model hits and potential hits, swamp the on-model risks by close to 1 000 to one," he writes.
There is an investment strategy to profit from improbability.
"Be as hyperconservative and hyperaggressive as you can instead of being mildly aggressive or conservative," Taleb advises. "Instead of having medium risk, you have high risk on one side and no risk on the other. The average will be medium risk but constitutes a positive exposure to the black swan."
With risk measures at or near record lows, including volatility indices, corporate bond defaults, credit spreads and emerging market yields, Taleb might help you dodge the next black swan.
Mark Gilbert is a columnist for Bloomberg News
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