“For instance, regulators in the banking business are prone to a severe expert problem and they tend to condone reckless but (hidden) risk taking. Andy Marshall and Andy Mays asked me if the private sector could do better in predicting. Alas, no. Once again, recall the [1982] story of banks hiding explosive risks in their portfolios. It is not a good idea to trust corporations with matters such as rare events because the performance of these executives is not observable on a short-term basis, and they will game the system by showing good performance so they can get their yearly bonus.”
(Nassim Nicholas Taleb, The Black Swan, p.209, published April, 2007, well before the height of the “subprime meltdown.” His comments underscore a painful lesson that companies like AIG, and taxpayers across the globe, were to learn not too long after his book was published.)
"Likewise, the government-sponsored institution Fanny Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup." (Taleb, The Black Swan, p.225-226n, published April, 2007, well before the height of the “subprime meltdown.”)
Why did World War I break out? Why did 9/11 happen? Why did the Internet come out of nowhere to exert a huge impact on our society?
Why did the stock market crash on 10/19/87, a crash so severe that it has been described as “27-standard deviation event” that should not have been experienced “even if one were to have lived through the entire 20 billion year life of the universe and experienced this 20 billion times …”? (This quotation is from a paper by Jackwerth and Rubinstein of Berkeley, taken from Scott Patterson’s The Quants, p.53.)
Most of us have heard explanations for at least some of the events described above. (All of us who took high school history have heard explanations for WWI, even if we don’t remember them.)
Perhaps, however, nobody really knows why these events took place. I’m in the process of reading a fascinating book called The Black Swan, a book that suggests exactly this – we don’t know why these events occurred and we have little chance of predicting the likelihood of other “major impact” events occurring.
This is one of those books that I really enjoy, even though I disagree with a fair amount that the author, Nassim Nicholas Taleb, has to say. I like the book because Taleb is an intellectual maverick, and I generally enjoy reading mavericks, as long as they don’t go off the deep end. Taleb, in my view, doesn’t.
From a big picture perspective, the book is about the limits of human knowledge. Taleb believes that we’ve vastly overestimated our ability to understand the world and to predict what is likely to happen. This has, as one might expect, major implications for decision making in business, for policy formulation in government, and in many other areas.
First, though, an explanation of the title. As Taleb tells the story, for a considerable period of time, Europeans believed that all swans were white, a belief was strengthened every time additional white swans were observed. However, lo and behold, some Europeans then traveled to Australia and found swans that were black.
There is no racial dimension to any of this; it’s only about birds, their coloring, and the limits to empirical observation. As Taleb states “The sighting of the first black swan might have been an interesting surprise for a few ornithologists (and others extremely concerned with the coloring of birds), but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans (p. xvii).”
At any rate, given that Taleb uses the notion of a “Black Swan” as a metaphor, the key characteristics of a “Black Swan” are the following:
1. It is unexpected – it’s an event that, prior to its occurrence, is viewed as highly unlikely.
2. It has a major impact.
3. Even though it was unexpected and unpredicted, we come up with after the fact "explanations" which imply that we really understood the situation all along. Taleb uses the phrase “narrative fallacy” to generally refer to such explanations, or “stories” as he calls them.
As a professor of business, and an amateur student of history, I find the third characteristic to be the most interesting. The business literature is full of books and articles that purport to tell us why certain companies succeeded and how we can replicate their success by doing the same things. Having worked in the technology industry for many years, I have always been suspicious of these books and articles, in part because I recall some written about the company I worked for that reflected a total lack of understanding of what was really going on inside the company.
(By the way, Taleb provides a great example of the narrative fallacy when he quotes two headlines from Bloomberg on the day of the capture of Saddam Hussein in December of 2003. One headline noted the rise of U.S. Treasury Bonds, and cited Hussein’s capture as a reason. Another headline, half an hour later, noted the fall of Treasury prices, and cited Hussein’s capture as the reason for that! See Taleb, 2007, p. 74.)
As mentioned above, I don’t agree with Taleb on a number of points, but The Black Swan is a book that makes one think, and in my view it’s well worth the purchase price.
Here are links to a few other pages I've created on specific topics from The Black Swan.