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The Black Swan by Nassim Nicholas Taleb

03/09/2013

The phrases known unknowns and unknown unknowns drew opprobrium and ridicule when popularised by George. W Bush’s secretary of defense Donald Rumsfeld in the context of the Iraq invasion of 2003. Rumsfeld’s rather baffling explanation (see here http://www.youtube.com/watch?v=GiPe1OiKQuk) cast a shadow over the usefulness of such concepts intended to help us consider the randomness and uncertainty of the world in which we live.

Nassim Nicholas Taleb’s book, The Black Swan, is an honest attempt to look at randomness and uncertainty in the world, how we should take risks and where we should minimise that risk so we are not obliterated by the big potential downsides or negative “black swans” and how we can benefit from the positive black swans. He uses the black swan as a metaphor for a game changer, prior to the discovery of a black swan, the statement “swans are white” was simply a truism because no one had evidence that black swans existed but absence of evidence is not evidence of absence. This is one of the many lessons Taleb teaches as he considers different realms of the world.

Mediocristan and Extremistan

Taleb views everything in our lives as existing within two distinct worlds which differ greatly in the level of certainty and the average results that we can expect. Mediocristan is the world where the average is meaningful and outliers and one end or the other of the spectrum do not substantially affect the average (the example he gives are people’s heights).

In Extremistan, which is the much more interesting world, extreme outliers can make a significant impact upon the average and the overall amount of output. This is the world where a bestselling book today can outsell the previous bestseller by a virtually infinite factor or a financial crisis can result in the loss  of all money previously made on the market. Extremistan is subject to Black Swans or random (somewhat) unprecedented events which can substantially impact upon and change the particular industry or sphere.

The Narrative fallacy

Taleb points out that many of these Black Swans have taken place because of a myriad of different factors and we should be careful of neat and tidy stories seeking to explain why things have happened the way they have. Correlation does not always equal causation. He tells us to beware of the narrative fallacy and post hoc rationalisations of major events. He illustrates the greater difficulty of backwards prediction rather than forward prediction by considering a melting ice cube. If I place an ice-cube upon a table in the middle of a hot summer’s day I can predict with reasonable confidence that the ice-cube will melt. However, if I encounter a puddle of water on the kitchen table when returning home, I cannot explain with any certainty how the puddle of water came to be on the table.

It is for this reason Taleb insists on skepticism of any academics, economists, politicians or bankers who have too much confidence in their mathematical models which are usually flawed and prone to be afflicted by unknown unknowns (sometimes they could be known if these people had more humility) or black swans. Taleb is an engaging and entertaining writer and a highlight of the book for me is his fantasy of dropping an ice cube or a rat down the shirt of a perfectly attired member of one of the professions above who are prone to become victims of their own hubris.

Creative Destruction

Taleb’s scorn for Politicians, Bankers and Economists is brought to bear in one of the few policy prescriptions he does make: that is his opposition to the controversial bail out of large banks in the wake of the global financial crisis. He considers evolution as a force whereby one thing must be destroyed so something better can be developed. In applying this notion to the banking sector, he invokes Joseph Schumpeter who famously wrote of capitalism as a system of creative destruction*. In the financial sector, if bankers expect to be bailed out by governments, then a bad system encourages bankers to continue to take bad risks without the inherent discipline of the market displacing the reckless lenders.

Theory vs. Practice

A central theme running through the book is the distinction of theory vs. practice – the statistician who concludes a coin which has landed 99 times heads has a fifty percent chance of landing tails on the hundredth toss vs the street wise trader who announces it must be a trick coin. This is a dichotomy that has merit for our world today as many of the most influential figures whether they be policy makers or bankers encouraged to take risks often do so based largely on theory rather than practice and as discussed above do not bear the consequences for their mistakes.

Conclusion

Taleb’s book is unashamedly intellectual and he writes with a style that challenges the reader but at the same time brings him along on a journey through many different spheres of life to illustrate his ideas. He involves a cast of interesting characters including philosophers, academics and fictional writers and financial traders. It is impressive that Taleb is able to bring professional knowledge from a trading floor and a remarkable depth of knowledge including ancient philosophical ideas such as stoicism and apply them to his central thesis with aplomb. However, what is more remarkable is despite Taleb’s obviously impressive intellect, he shies away from making many policy prescriptions and is brave enough to admit there is still much he does not know and much that he like anyone can never know.

This is a considered book written by a genuine thinker who is able to bring the powers of both theory and practice to the fore whilst simultaneously demonstrating the limitations of the former. Although he disdains the descriptor for its connotation of hubris within the ivory tower, Taleb is an intellectual of the best sort. Read this book.

*Schumpeter coined the phrase in his famous book Capitalism, Socialism and Democracy

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One Comment
  1. Nathan Rose permalink

    I am re-reading The Black Swan.

    For me the highlight of the book is how eloquently it explains human progress – both at the level of the individual at at the level of civilisation at large – as being the product of large, non-continuous, unpredictable jumps (both positive and negative)… and importantly, how this fact is completely NOT in keeping with our human nature.

    We have minds that expect effort to yield results in a steady fashion – our hormonal systems even reward us for ‘frequent’ wins instead of the ‘net result’ of actions, meaning the employee who makes a comfortable $200,000 a year every year is actually likely to be happier than someone who toils for 10 years on the breadline before striking oil (or writing that bestseller, or discovering a cure for cancer etc) and making many tens of millions. The employee has had consistent small wins (and is thus given regular hits of dopamine by his limbic system) – the speculator has had just one – but, flawed hormonal systems aside, it’s enough to strike oil once in life.

    We are horrible at predicting, but we do not know it. We think that because we are good at explaining the past, we can extrapolate into the future.We ignore that our previous predictions of the future have almost always proven to be completely wrong. When quizzed on why the forecasts were wrong, forecasters will point to an unforeseeable ‘outlier’, or an event that had never happened before. The outliers are what matters MOST in history, but academic and commercial training tells us to exclude them from our models – mostly because including them mucks up our nice correlation that seduces us into thinking we can predict something as wildly random as the future using something so dry and artificial as a mathematical model.

    Why do outliers matter most? Imagine sitting in 1984 trying to predict what 2014 would look like. To get an accurate picture, you would need to forecast personal computers, the collapse of communism, 9/11, the presidency of George W. Bush, the global financial crisis, formerly basketcase Asian countries stabilising politically and growing rapidly and the rise of social media (on the internet, which itself did not exist in our imagination) to name a few – none of these things were foreseeable, but have all have shaped the last 30 years more than anything ‘predictable’ at the time. What shapes the next 30 years (to 2044) is going to be just as unpredictable to us today, if not more so.

    What are the implications?
    We should realise we are truly horrible at assessing the probabilities of events. We are a bit better at assessing the impact those events might have on us. (i.e. I don’t know how likely it is an earthquake will hit Wellington next year, but I can imagine it will be pretty damn bad if it does).

    1. We should setup our lives, as much as possible to not be hurt by the negative Black Swans when they come. This is hard to do, because the nature of Black Swans is the ones that hurt us the most are the ones we didn’t predict – but things like insuring your home against EVERY eventuality (not excluding ‘acts of god’ or ‘warfare’ or ‘global warming’ as some policies do), maintaining the majority of your wealth in risk-free assets (not so-called ‘diversified’ ones which actually all go down in value at the same time when a crash happens), and living within your means so that losing your job will not mean you cannot pay the massive mortgage you’ve taken out or your credit card repayments on the 50″ plasma TV are good places to start.

    2. We should setup our lives to benefit from ‘serendipity’ – i.e. the positive Black Swans that some people call “luck”. You might think that pretty girl / handsome guy sitting across the cafe is unlikely to be interested in you – but imagine the positive payoff if they turn out to be your future life partner! Remember that individual lives move in jumps rather than steady progression too – most people meet their life partner due to proximity at some chance encounter, progress their career due to a lucky break, or decide to hop on a plane to some far-flung country where their whole life changes unexpectedly. Taleb doesn’t like the example of lotto tickets (it “Platonifies” randomness too much), but they are a good mental guide – to win the lottery, you need to buy a lotto ticket. We must give ourselves the chance to be lucky.

    3. We should stop taking seriously people who claim to be able to predict the future. If they can’t predict the outliers (and no-one can), then they can’t predict anything worthwhile. Instead we should listen to leaders who have good ways of setting up society to be robust to the outliers when they come.

    This was originally going to be a rather short post – it’s turned into an essay! As you can tell, this book has had an impact on me. Read this book.

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