Sfetcu, Nicolae (2022). Black Swan, an assumed risk – Is it worth it? DOI: 10.13140/RG.2.2.25379.94241, in Telework: https://www.telework.ro/en/black-swan-an-assumed-risk-is-it-worth-it/

Abstract

Book review: Taleb, Nassim Nicholas (2007), The Black Swan: The Impact of the Highly Improbable, Random House, ISBN 978-1400063512

The book tackles subjects related to knowledge and ways of life, with elements of fiction and anecdotes from the author’s personal life, starting from literary aspects to scientific and mathematical ones. The focus is on our blindness to randomness, especially large deviations.

The Black Swan theory was developed by Nassim Nicholas Taleb to explain the disproportionate role of hard-to-predict rare events, the inconsistency of scientific methods in calculating the probability of rare events due to the nature of small probabilities, and people’s biases towards uncertainty and the massive role of a rare event. Taleb suggests that businessmen use the “barbell strategy” for investing that he himself used, which consists of avoiding medium-risk investments and placing 85-90% of the money in the safest instruments available and the remaining 10- 15% in highly speculative business.

Keywords: Black Swan, Black Swan theory, Nassim Nicholas Taleb, review

Black Swan, an assumed risk – Is it worth it?

Nicolae Sfetcu

Introduction

Nassim Nicholas Taleb wrote the book The Black Swan: The Impact of the Highly Improbable in 2007, with the second edition in 2010, (N. N. Taleb 2010a) developing a theory according to which rare and unpredictable events, for which retrospective explanations are found, have a very high impact that must be taken into account. Black Swan is Taleb’s second book in a five-volume series entitled Incerto, (N. N. Taleb 2021) which includes Fooled by Randomness (2001), (N. N. Taleb 2008d) The Black Swan (2007–2010), The Bed of Procrustes ( 2010–2016), (N. N. Taleb 2010b) Antifragile (2012) (N. N. N. Taleb 2014) and Skin in the Game (2018). (N. N. Taleb 2018) (Paul 2018)

Nassim Nicholas Taleb is a Lebanese-American essayist, mathematical statistician, former options trader, and risk analyst. (Berenson 2009) He was born in Amioun, Lebanon, (N. N. Taleb 2008a, 17) with parents of Antiochian Greek origin. He received BA and MA degrees from the University of Paris, (The New York Times 1988) and holds an MBA from the Wharton School of the University of Pennsylvania (1983), (Patterson 2008) and a PhD in Management Science from University of Paris (Dauphine) (1998), with thesis on the mathematics of derivative prices. (BBK 2015)

Taleb became financially independent after the financial crash of 1987, (Baker-Said 2008a) the Nasdaq collapse of 2000, (Stone 2005) and during the financial crisis that began in 2007. (Patterson 2008) He retired from trading in 2004 focusing on writing his books. (Patterson 2007) Became a research mathematician, scholar and philosophical essayist in 2006, holding various academic positions. (N. N. Taleb 2022) He is co-editor-in-chief of the academic journal Risk and Decision Analysis (since September 2014).

In late 2015, Taleb, Robert J. Frey, and Raphael Douady formed the Real World Risk Institute ” to build the principles and methodology for what we call real-world rigor, in decision making and codify a clear-cut way to approach … to provide executive education courses and issue two certificates.” (NECSI 2022)

Taleb called for the cancellation of the Nobel Prize in Economics, saying the damage caused by economic theories can be devastating. (N. N. Taleb 2007a) He opposes top-down knowledge as an academic illusion, and states that models are nothing more than “teaching birds how to fly”. (Roberts 2009)

The term black swan has roots in antiquity. Aristotle’s “First Analytic” uses examples of syllogisms involving the expression white swan as an example of necessary relations and black swan as improbable. In the poet Juvenal’s phrase in Satire VI ” a good person is as rare as a black swan “, (Puhvel 1984) was later used as a statement describing the impossibility, since all historical records of swans reported that they had white feathers. (N. N. Taleb 2008b) Later, in 1697, Dutch explorers led by Willem de Vlamingh discovered black swans in Australia. (Groarke 2009) (Parliament 2009) In the 19th century, John Stuart Mill used the black swan fallacy as a new term to identify falsification. (Hammond 2009) Thus it would follow that no form of reasoning is infallible, because in inductive reasoning, the premises of an argument may support a conclusion but not ensure it, and in deductive reasoning, an argument is dependent on the truth of its premises.

The book was described by The Sunday Times as one of the twelve most influential books since the Second World War. (The Sunday Times 2009) As of December 2020, it has been cited approximately 10,633 times, of which 9,000 are for the English edition. (Google Scholar 2022) The book spent 36 weeks on the New York Times Best Seller List; (Baker-Said 2008b) It has been published in 32 languages.

Nobel Prize-winning psychologist Daniel Kahneman wrote that “The Black Swan changed my view of how the world works.” (Kahneman 2013)

Subjects

The book deals with subjects related to knowledge and ways of life, with fictional and anecdotal elements from the author’s personal life, ranging from literary aspects to scientific and mathematical ones. The focus is on ” our blindness with respect to randomness, particularly large deviations.” (N. N. Taleb 2010a, xix)

The first two parts of the book are more psychological. The author considers history to be opaque, a “black box”, an idea argued by the triplet of opacity (an illusion of understanding in which we think we understand a complicated world). (N. N. Taleb 2010a, 8) (Yetiv 2013) The second chapter exemplifies the theory by presenting a hypothetical female scientist, (Li 2016) Yevgenia Nikolayevna Krasnova, who has a resounding and unexpected success with her first published book, but fails at the second book published although everyone expected to continue the success story. Taleb states that there are two black swans here, (Hampton 2009) the first positive and the second negative. It should be noted that (Easterbrook 2007) considers the sequence of events in this history as a cliché of the publishing industry. Taleb fabricated the character, acknowledging only in a footnote and index, instead of addressing a real topic of history where he would not have had to invent his examples.

In the second half of part two and in part three he turns to science and business. He develops the Black Swan theory through the concepts of extremistan (where a Gaussian distribution should be used at one’s own risk (Salmon 2009)) and mediocristan (events that can safely use the Gaussian distribution), (Sandis 2014) arguing his ideas by citing Benoit Mandelbrot with fractal or power laws and his critique of the Gaussian distribution. (Davies 2007)

The fourth part consists of tips on maximizing positive black swan events and minimizing negative ones, giving the example of a turkey that is a surprise that it will be cooked on Thanksgiving Day, but this event is not a surprise to its butcher. Everyone’s objective is to “avoid being a turkey”, by identifying areas of vulnerability to “whiten black swans”. (Chevallier 2016)

Taleb discusses the “epistemic arrogance” of people who come to believe they know more than they actually do, (Gould 2009) resorting to ad hominem attacks if he finds nothing in a person’s idea worth attacking, but he himself cannot resist attacks both, characterizing adherents of Gaussian statistics as boring and unimaginative “empty suits”. (Carmody 2017)

Taleb suggests that businessmen use the “barbell strategy” for investing that he himself used, which consists of avoiding medium-risk investments and placing 85-90% of the money in the safest instruments available and the remaining 10- 15% in highly speculative businesses: (Farrell 2011) (Collins 2018)

”Half the time I am hyperconservative in the conduct of my own affairs; the other half I am hyperaggressive. This may not seem exceptional, except that my conservatism applies to what others call risk taking, and my aggressiveness to areas where others recommend caution. I worry less about small failures, more about large, potentially terminal ones. I worry far more about the “promising” stock market, particularly the “safe” blue chip stocks, than I do about speculative ventures—the former present invisible risks, the latter offer no surprises since you know how volatile they are and can limit your downside by investing smaller amounts. I worry less about advertised and sensational risks, more about the more vicious hidden ones. In the end this is a trivial decision-making rule: I am very aggressive when I can gain exposure to positive Black Swans—when a failure would be of small moment—and very conservative when I am under threat from a negative Black Swan. I am very aggressive when an error in a model can benefit me, and paranoid when the error can hurt. This may not be too interesting except that it is exactly what other people do not do. In finance, for instance, people use flimsy theories to manage their risks and put wild ideas under “rational” scrutiny.” (N. N. Taleb 2010a, 295–96)

Taleb mentions several books in his bibliography that he drew inspiration from, but does not credit them in his text. He ridicules distinguished economists while portraying himself as a lonely, persecuted genius. (Easterbrook 2007)

Black Swan Theory

The Black Swan theory was developed by Nassim Nicholas Taleb to explain the disproportionate role of hard-to-predict rare events, the inconsistency of scientific methods in calculating the probability of rare events due to the nature of small probabilities, and people’s biases towards uncertainty and the massive role of a rare event. Although initially Taleb spoke of black swans only in the financial field, in 2007 in The Black Swan he extended the metaphor to events outside of financial markets, considering almost all major scientific discoveries, historical events and artistic achievements to be “black swans”. (N. N. Taleb 2010a) According to Taleb:

”What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme ‘impact’. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. I stop and summarize the triplet: rarity, extreme ‘impact’, and retrospective (though not prospective) predictability. A small number of Black Swans explains almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives.” (Baker-Said 2008a)

It follows that a black swan event is a surprise (to the observer), has a major effect, and after the first recorded instance of the event is rationalized in retrospect (we think of past events as linked to causal explanations, partly to ease our recall but narrative makes us see past events as more predictable, more expected, and less random than they actually were (“narrative failure”). (N. N. Taleb 2010a, 73) Taleb speaks of “playful failure” which consists in the error of compare randomness in the real world to the “structured randomness” of quantum physics, where probabilities are calculable, or gambling where probabilities are intentionally constructed by the owners: ” The dark side of the moon is harder to see; beaming light on it costs energy.” (Kushal and Illindala 2020)

Taleb criticizes the use of the normal distribution model used in financial engineering, calling it a great intellectual fraud. Statistical fluctuations and simple regressions of the type most often treated by financial models capture the monotonous and predictable behavior of a system, but completely ignore the existence of intrinsic and fundamental phenomena that can have major effects. In the second edition of The Black Swan, Taleb offers ” Ten Principles for a Black-Swan-Robust Society.” (N. N. Taleb 2009b) Postulated that the foundations of quantitative economics are flawed and highly self-referential, and statistics is fundamentally incomplete as a field, as it cannot predict the risk of rare events (the problem of statistical undecidability). (Douady 2010)

Taleb’s black swan refers to a phenomenon with specific empirical and statistical properties, which he calls the “fourth quadrant”. (N. N. Taleb 2008c) In the “fourth quadrant”, knowledge is uncertain and consequences are high, requiring more robustness. For Taleb, ” normal is often irrelevant… ‘bell curve’ methods of inference that tell you close to nothing. Why? Because the bell curve ignores large deviations, cannot handle them…” (N. N. Taleb 2007b) Decision theory ignores and minimizes the effect of events that are “outside the model”. A fixed model considers “known unknowns” but ignores “unknown unknowns” (Donald Rumsfeld (Newhouse 1982)) Taleb also advocates the use of counterfactual reasoning when considering risk. (N. N. Taleb 2007b, xvii) (Gangahar 2008) The concept of the “fourth quadrant” (N. N. Taleb 2009a) is applied by Taleb in his definition of the most effective risk management approach: what he calls the “barbell strategy”, which is relies on avoiding the middle in favor of a combination of extremes in all areas, including health and exercise, where it suggests that it is better to do low-effort exercise, such as slow walking most of the time, while occasionally exert extreme effort.

According to Taleb’s summary of the Black Swan theory: (N. N. Taleb 2010a, 50)

We focus on preselected segments of the seen and generalize from it to the unseen: the confirmation bias.
We fool ourselves with stories that satisfy our Platonic thirst for distinct patterns: the narrative fallacy.
We act as if the Black Swan does not exist; human nature is not programmed for black swans.
What we see is not necessarily all that is there. History hides our Black Swans [if they did not happen] and gives us the wrong idea of the chances of these events: this is the distortion of silent evidence.
We “tunnel”: that is, we focus on a few well-defined sources of uncertainty, on an overly specific list of black swans (at the expense of others that do not come to mind so easily).

Taleb’s basic idea is to build resilience (Krishnadas 2015) to negative events and the ability to exploit positive events, stating that banks and commercial firms are the most vulnerable to black swan events due to their flawed financial models. But he supports this claim with anecdotes and rhetoric, rather than data and analysis.

Style

The style of the book is rather anecdotal, popular science, unstructured, encompassing complex ideas in simple metaphors, through excessive simplicity:

” … this book is a story, and I prefer to use stories and vignettes to illustrate our gullibility about stories and our preference for the dangerous compression of narratives…. You need a story to displace a story. Metaphors and stories are far more potent (alas) than ideas; they are also easier to remember and more fun to read.” (N. N. Taleb 2010a, xxvii)

Of note are his particularly aggressive and clearly directed comments against parts of the financial industry, sprinkled with rather scattered philosophical ideas and constant references to Bertrand Russell as an “uberphilosopher“. Taleb’s philosophizing style approaches straw man rhetoric; much of the book is rhetoric about empiricism, with a remarkable lack of actual empiricism, that is, rational arguments from data. (Aldous 2009)

Conclusions

David Aldous has argued that Taleb is an expert on the financial markets but tends toward irrelevance or ridiculous exaggeration in his book. (Aldous 2009)

Taleb rejects normal, Gaussian, mediocristan forecasts as uninteresting, and praises the extremistan, (N. N. Taleb 2010a, xix) but the prevalence of the extremist is greatly exaggerated, as it applies in extremely specific and isolated situations. The practical application of the Black Swan theory actually involves assuming a significant risk by “gambling” on extremely improbable events that would have a major impact. Taking that kind of risk isn’t just about math. It involves taking into account the temperament of the person who assumes it, and his social and economic-financial context. A life dominated only by the laws of power is very likely to fail in the end. One solution would be a trade-off between short-term risk and long-term reward, going on the common-sense assumption that the future will be statistically similar to the past.

In an interview with Charlie Rose, Taleb states that none of the criticism received for Black Swan has dismissed its central idea. (Rose 2008)

Let’s imagine that Taleb’s theory is correct, and that a great Black Swan with devastating life and death effects awaits us all soon. Should we risk everything by acting in the extremistan in this direction, or should we remain in the mediocristan? Is it worth it?

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