Taking improbable events seriously: An interview with the author of The Black Swan
The scholar, trader, and author Nassim Nicholas Taleb brings a decidedly contrarian view to the world of finance, statistics, and risk. In 2007, he published The Black Swan: The Impact of the Highly Improbable, which argues that we should never ignore the possibility or importance of rare, unpredictable events. In this interview with the Quarterly, he looks at the current financial crisis through the lens of his Black Swanthinking.
The Quarterly: For people who haven’t read The Black Swan, can you quickly summarize what they should know to understand your point of view on recent events in global financial markets?
Nassim Nicholas Taleb: Before Europeans discovered Australia, we had no reason to believe that swans could be any other color but white. But they discovered Australia, saw black swans, and revised their beliefs. My idea in The Black Swan is to make people think of the unknown and of the potency of the unknown, particularly a certain class of events that you can’t imagine but can cost you a lot: rare but high-impact events.
So my black swan doesn’t have feathers. My black swan is an event with three properties. Number one, its probability is low and based on past knowledge. Two, although its probability is low, when it happens it has a massive impact. And three, people don’t see it coming before the fact, but after the fact, everybody saw it coming. So it’s prospectively unpredictable but retrospectively predictable.
Now that we’re in this financial crisis, for example, everybody saw it coming. But did they own bank stocks? Yes, they did. In other words, they say that they saw it coming because they had some thoughts in the shower about this possibility—not because they truly took measures to protect themselves from it.
Now, a black swan can be a negative event like a banking crisis. It also can be positive: inventing new technology, making new discoveries, meeting your mate, writing a best seller, or developing a cure for cancer, baldness, or bad breath. In The Black Swan, I say that in the historical and socioeconomic domain, black swans are everything. If you ignore black swans, you’ve got nothing. And I showed that the computer, the Internet, and the laser—three recent technological black swans—came out of nowhere. We didn’t know what they were, and when we had them right before our eyes we didn’t know what to do with them. The Internet was not built as something to help people communicate in chat rooms; it was a military application and it evolved.
So these things have a life of their own. You cannot predict a black swan. We also have some psychological blindness to black swans. We don’t understand them, because, genetically, we did not evolve in an environment where there were a lot of black swans. It’s not part of our intuition.
The Quarterly: Say a little more about the relationship between black swans and the global financial crisis.
Nassim Nicholas Taleb: I warned in The Black Swan against some classes of risk people don’t understand and against the tools used by risk managers—tools that could not fully capture the properties of the world in which we live. The financial crisis took place because people took a lot of hidden risks, which meant that a small blip could have massive consequences.
In fact, I tried in The Black Swan to turn a lot of black swans white! That’s why I kept going on and on against financial theories, financial-risk managers, and people who do quantitative finance. I warned that they were dangerous to society.
The Quarterly: You question many of the underpinnings of modern financial theory. If you were the dean of a business school, how would you overhaul the curriculum?
Nassim Nicholas Taleb: I would tell people to learn more accounting, more computer science, more business history, more financial history. And I would ban portfolio theory immediately. It’s what caused the problems. Frankly, anything in finance that has equations is suspicious. I would also ban the use of statistics because unless you know statistics very, very well, it’s a dangerous, double-edged sword. And I would ban linear regression. All these things don’t work.
The Quarterly: What are your concerns with statistics and portfolio theory?
Nassim Nicholas Taleb: The field of statistics is based on something called the law of large numbers: as you increase your sample size, no single observation is going to hurt you. Sometimes that works. But the rules are based on classes of distribution that don’t always hold in our world.
All statistics come from games. But our world doesn’t resemble games. We don’t have dice that can deliver. Instead of dice with one through six, the real world can have one through five—and then a trillion. The real world can do that. In the 1920s, the German mark went from three marks to a dollar to three trillion to a dollar in no time.
That’s why portfolio theory simply doesn’t work. It uses metrics like variance to describe risk, while most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk. It’s very foolish to use variance.
The Quarterly: Does your thinking inform the debate over the efficient market hypothesis?
Nassim Nicholas Taleb: I have no idea. I don’t know if markets are efficient or inefficient. I don’t know if we’ll ever know. And I don’t know if it’s relevant.
The Quarterly: What does all this mean for managers at nonfinancial companies? What should they be doing differently?
Nassim Nicholas Taleb: I recommend two things. Number one, take the maximum amount of risk and other forms of exposure to positive black swans when this costs you very little if you’re wrong and earns you a lot if you’re right. Number two, minimize your exposure to negative black swans.
This is exactly the opposite of what the banks did. They had no real upside and a lot of downside—or, to be more precise, they got a little bit of cash flow to have all the downside. I recommend the opposite. Be hyperconservative when it comes to downside risk, hyperaggressive when it comes to opportunities that cost you very little. Most people have the wrong instinct. They do the opposite.
The Quarterly: What would your ideas look like in practice for, say, a manufacturer?
Nassim Nicholas Taleb: If risk doesn’t cost you a lot, take all the risk you can. That’s how economic growth is generated. Don’t fear being aggressive if that only costs you a little. Do more trial and error. Learn to fail with pride, comfort, and pleasure.
But try to have less downside exposure by building more slack into your system through redundancy, more insurance, more cash, and less leverage. Imagine a shock. What will happen if there’s a shock? How many months could you keep operating?
The problem is, Wall Street penalizes companies that have more of this kind of insurance, because they are going to lag behind companies that don’t take on the expense. I see this in my investment business. But you know what? The people who insured against catastrophes are still standing today. The other people are bust. So don’t fear overinsurance for your downside, even if you lag behind as a result.
The Quarterly: You’re a critic of scenario planning. Is there a way to do it effectively?
Nassim Nicholas Taleb: I don’t like scenario planning, because people don’t think out of the box. So scenario planning may focus on four, five, or six scenarios that you can envision, at the expense of others you can’t. Instead of looking at scenarios and forecasts, you should be looking to see how fragile your portfolio is. How vulnerable are you to model error? How vulnerable is your cash flow to changes in any parameter of your calculations? My idea is to base your navigation on fragility.
The Black Swan Theory of change
From The Black Swan is published by Penguin on May 3. http://www.buzzle.com/articles/135661.html
Last year, the multi-millionaire publisher Felix Dennis wrote a book entitled How To Get Rich: The Distilled Wisdom of One of Britain's Wealthiest Entrepreneurs. It is significantly less annoying than most such works, thanks mainly to the author's willingness to admit to the sheer fun of being worth around £700m. "Five homes. Three estates. Fancy cars. Private jets," Dennis wrote, enumerating the benefits. "Chauffeurs, housekeepers, financial advisers ..." Beneath the disarming tone, though, Dennis's volume conveys the same message as hundreds of others in which the rich reveal their secrets. All argue that to make a fortune, you need certain characteristics: confidence, perseverance, and little fear of failure. The implication is clear: I, the wealthy author, possess these qualities; that's how I became rich.
It seems a big and perhaps tasteless leap from Dennis's life of luxury to last week's campus killings in Virginia. But a similar logic was at work. In hindsight, after he had murdered 32 people, it was obvious there had always been something suspicious about Cho Seung-hui. He wrote violent plays, intimidated female students, and - like serial killers since the dawn of time - kept himself to himself. "Cho was crazy; plenty of people knew he was crazy; he should have been locked up," the rightwing blogger John Derbyshire wrote at National Review Online.
This kind of armchair smugness is the special preserve of rightwing bloggers. But the error it embodies is far more widespread. We are chronic explainers: once an event has occurred, we hurry to create a narrative that makes it look as if it was predictable. But what if we could never have predicted that Cho's life would unfold differently from those of all the other taciturn loners? Likewise, on what grounds can Dennis attribute his success to perseverance and boldness - rather than, say, dumb luck? Hundreds of thousands of people, surely, display the same qualities, yet they don't reach the same heights.
This is the central mystery that preoccupies the essayist and former Wall Street trader Nassim Nicholas Taleb. Why are we so bad at acknowledging life's unpredictability? Things happen, and surprise us. Afterwards, we act as if they were explicable all along. Then we use those explanations to pretend we can control the future: act boldly, and you'll become rich; keep an eye on loners, and you'll prevent massacres. "There's just much, much more luck than we think," Taleb says, rocking excitably on his chair in a London cafe.
This is not just an amusing quirk of human nature: it matters. It explains, among other things, why a campaigner who suggested reinforcing aeroplane cockpit doors prior to 9/11 would never have prevailed - and thus it explains, in a sense, why 9/11 happened. It explains why City high-flyers receive vast bonuses, based on the unprovable belief that they possess unique skills.
And it may have explained the insouciance of a sea captain, quoted by Taleb, who reportedly wrote in 1907 that "I never saw a wreck, and nor was I ever in any predicament that threatened to end in disaster of any sort." On the basis of experience, this captain might have concluded, he didn't need to worry too much about future journeys. Five years later he commanded a liner that set sail from Southampton, bound for New York, with 2,208 people on board. The seas off Newfoundland were icy. You know the rest.
According to Taleb's new book, The Black Swan, life is infused with unpredictability. Almost everything really significant that happens - in the grand sweep of history, or in our personal lives - is what he calls a black swan event. The label evokes an old philosophical observation: you might believe in the truth of the statement "all swans are white", but no matter how many white swans you see, you can never prove it for certain. On the other hand, a single, unexpected sighting of a black swan completely disproves it. Black swan events are shocking when they happen, and their impact is huge - but in retrospect, they seem predictable. The September 11 attacks were a black swan; so was the Virginia massacre. And black swans, Taleb argues, are getting worse: in our global, electronically connected world, randomness is magnified. Things spin more rapidly out of control, whether copycat killings, or sales of Harry Potter books.
We can't get much better at predicting. But we can get better at realising how bad we are at predicting. Taleb has the dubious honour of having inspired the former US defence secretary, Donald Rumsfeld, to make his speech about "unknown unknowns". (He had outlined his ideas to Rumsfeld's aides some time earlier.) "But I don't want to be advertised as someone who's too close to these people," Taleb sighs today.
Rumsfeld's "unknown unknowns" speech made perfect sense. The problem, Taleb says, was that Rumsfeld himself didn't understand it. The black swan way of thinking should have prompted the defence secretary to be cautious about his capacity to predict the future in Iraq. Instead, he fell, again and again, into the prediction trap.
If you are aware of your own ignorance, though, you can use it to make money, as Taleb did on Wall Street, as an options trader. Options are gambles about what the market will do. To sell an option to somebody else, you need to be confident you have some kind of theory about what will happen in the future. If you're right, you make a small amount of money; if you're wrong, you lose lots. Taleb, however, realised he had no theories. So he exploited everyone else's confidence, buying options according to no particular prediction. Most days, his rivals made a small amount of money, and he lost a small amount. But the one thing he could predict was that, if he waited long enough, something unpredictable would happen. When it did, some of his rivals would lose millions, and Taleb would make millions. It happened often enough for him to turn a big profit. It takes a rebellious nature, and an iron stomach, to go against the flow for so long. It is, perhaps, the kind of mindset that comes naturally to someone who lived through the Lebanese civil war - a classic, unpredictable black swan - and then found himself living as an exile, at one remove from American society. We are not all so good at resisting the herd's way of thinking. Take, for example, this article. It is ridiculous for me to suggest, off the cuff, that Taleb's experience of the Lebanese war, or being an exile, made him who he is today. I haven't located a sample of other exiles, or other Lebanese people, in order to calculate the rate at which they become mavericks like Taleb - so what do I know?
This is the kind of thought liable to make a journalist question his career choice. You actually reduce your knowledge by consuming news, Taleb argues, because the media can not filter out the vast majority of facts that turn out to be irrelevant. Besides, for reporters, the temptation to make things look explainable in retrospect is irresistible. Taleb recalls the alert that flashed up on Bloomberg News when Saddam Hussein was discovered hiding in a hole: US Treasuries Rise; Hussein Capture May Not Curb Terrorism. But treasury bonds fluctuated that day; they usually do. Half an hour later, they were down, and a new Bloomberg alert flashed up: US Treasuries Fall; Hussein Capture Boosts Allure of Risky Assets. After all, there had to be a sensible reason why the price had changed, didn't there? And so Bloomberg found one. Saddam's capture had caused the price to rise. Or fall. One of the two.
History begins to look strange when you see it in black swan terms. Irwin, the young teacher in Alan Bennett's play The History Boys, urges his students to think about "the moments when history rattles over the points" - times of spine-tingling potential, imbued with the feeling that things could go in radically different directions. ("When Chamberlain resigned as prime minister, Churchill wasn't the first thought," one of the boys muses, playing along.")
Irwin's real-life inspiration, The Scottish-born historian Niall Ferguson, is largely responsible for the growing profile of "counterfactual history" - the enterprise based on asking "what if?" What if (to be a little more frivolous than Ferguson would allow) the Archduke Franz Ferdinand's driver had taken a different route through Sarajevo? What if an aspiring Austrian painter named Adolf had found success as an artist?
"We see a great event like the first world war, or even a not-so-great event like the Virginia Tech shootings, and we think, 'Gosh, that must have had commensurately great causes, let's go and find them,'" Ferguson says. "So we find the role of German naval building, or colonial rivalries, but the problem with that approach to historical explanation is that no contemporaries saw these chains of causation leading to global war ... It's perfectly possible for an event as large as the first world war to have had quite proximate, small causes - that an assassination in Sarajevo really could cause four and a quarter years of carnage."
Marxist-influenced historians, predisposed to view history as the unfolding of economic structures, have long disdained this approach: EH Carr called it a "parlour game"; EP Thompson called it "unhistorical shit". If you are no longer anchored to what really happened, don't you just float free into aimless speculation?
"If you look at major historical events, the outcome is not random or simply contingent," says the (non-Marxist) historian Ian Kershaw, whose latest work on the second world war, Fateful Choices, has a counterfactual flavour, though he rejects the label. "There are developments which predispose the outcome, and the job of the historian is to work out what are the predisposing elements, and what is truly contingent." In January 1933, there were lots of reasons why Hitler was likely to come to power: that outcome was predisposed. But it wasn't certain: there were things that President Hindenburg could have done to stop it.
We can debate how far to carry black swan thinking in history. What seems certain, though, is that we could all do with applying it more in our own lives. This week, reporters thronged to the door of Alec Holden, from Surrey, who had placed a bet that he would live to 100. Now that he had won the bet, the media had one question: what was the secret of his longevity?
Eating porridge each day, Mr Holden replied. And taking holidays, and not worrying about things. It makes sense. Then again, how many people do all those things, but die much sooner? And what of the alternative explanation sometimes offered by the very old: that a little of what you fancy - gin, cigars - does you good? That explanation makes sense, too. Then again, it might all be chance. The point is that we cannot know. The least we could do is admit it.
AND also, Download The Black Swan in Arts and literature www.fooledbyrandomness.com/ARTE.pdf
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