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The Black Swan Theory and Nassim Nicholas Taleb



“If the Black Swan hits me, will it help me or hurt me?”



Nassim Nicholas Taleb
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Nassim Nicholas Taleb (Arabic: نسيم نيقولا نجيب طالب‎, alternatively Nessim or Nissim) was born in 1960 at Amioun, Lebanon, and is now a Lebanese American essayist.

He is a bestselling author, and has been a professor at several universities, currently at Polytechnic Institute of New York University and Oxford University. He is also a practitioner of mathematical finance. Taleb has been a hedge fund manager, a Wall Street trader, and is currently a scientific adviser at Universal Investments and the International Monetary Fund.

He criticized the risk management methods used by the finance industry and warned about financial crises, subsequently making a fortune out of the late-2000s financial crisis. He advocates what he calls a "black swan robust" society, meaning a society that can withstand difficult-to-predict events. He favors "stochastic tinkering" as a method of scientific discovery, by which he means experimentation and fact-collecting instead of top-down directed research.

Taleb’s work focuses on problems of randomness and probability. His 2007 book The Black Swan was described in a review by Sunday Times as one of the twelve most influential books since World War II.

The Black Swan Book

The Black Swan: The Impact of the Highly Improbable is a literary/philosophical book by the epistemologist Nassim Nicholas Taleb. The book focuses on the extreme impact of certain kinds of rare and unpredictable events (outliers) and humans' tendency to find simplistic explanations for these events retrospectively, after the fact. This theory has since become known as the black swan theory.

The book also covers subjects relating to knowledge, aesthetics, and ways of life, and uses elements of fiction in making its points.

The 2007 edition was a commercial success. It spent 17 weeks on the New York Times best-seller list.

video of taleb


Author Nassim Nicholas Taleb discusses the central theme of his bestselling book, "The Black Swan: The Impact of the Highly Improbable."


To watch this video click here.


Summary of the Book

Nassim Nicholas Taleb refers to the book variously as an essay or a narrative with one single idea: "our blindness with respect to randomness, particularly large deviations." It is Taleb's questioning of why this occurs and his explanations of it that drive the book forward.

The book's layout follows "a simple logic" moving from literary subjects in the beginning to scientific and mathematical subjects in the later portions. Part One and the beginning of Part Two delve into Psychology. Taleb addresses science and business in the latter half of Part Two and Part Three. Part Four contains advice on how to approach the world in the face of uncertainty and still enjoy life.

Taleb acknowledges a contradiction in the book. He uses an exact metaphor, Black Swan Idea to argue against the "unknown, the abstract, and imprecise uncertain--white ravens, pink elephants, or evaporating denizens of a remote planet orbiting Tau Ceti."

There is a contradiction; this book is a story, and more people 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.

Sale Success

As of March 2009 according to Slate, The Black Swan sold close to 1.5 million copies. It also spent seventeen weeks on the New York Times Bestseller list and was translated into twenty-seven languages.

A Mindmap Viewpoint of the Book

mindmap of black swans

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How Does the Black Swan Impact You and Trading?

You need to ask, “If the Black Swan hits me, will it help me or hurt me?” You cannot figure out the probability of a Black Swan hitting. But if you’re in a business that’s prone to negative Black Swans, like stock market investing, then you need to take forecasting seriously — and to think about how best to cope or profit from the situation!. You want to have situations where you can have as much of the good uncertainty as possible, where nothing too bad can happen to you, and where you have as many profitable options, as possible, available to you. Technology, today, is one example about maximizing options -- it’s similar to venture capital -- most of the money you make is from things you weren’t looking for -- but you can find them only if you search.

The Black Swan and the Stock Market

Nassim Nicholas Taleb was profiled by Malcolm Gladwell in the New Yorker in 2002 . There his work at his trading firm describes how his trading focused on the fat tails of probability distributions:-

The definition of a fat-tailed distribution is a probability distribution that has the property, along with the heavy-tailed distributions, that they exhibit extremely large skewness or kurtosis. This comparison is often made relative to the ubiquitous normal distribution, which itself is an example of an exceptionally thin tail distribution, or to the exponential distribution. Fat tail distributions have been empirically encountered in a fair number of areas: economics, physics, and earth sciences. Fat tail distributions have power law decay in the tail of the distribution, but do not necessarily follow a power law everywhere.

fat tails


Nassim Taleb, and his team at Empirica, were classed as quants. But they rejected the quant orthodoxy, because they don’t believe that things like the stock market behave in the way that physical phenomena like mortality statistics do. Physical events, whether death rates or poker games, are the predictable function of a limited and stable set of factors, and tend to follow what statisticians call a “normal distribution,” a bell curve. But do the ups and downs of the market follow a bell curve?

The economist, Eugene Fama, once studied stock prices and pointed out that if they followed a normal distribution you’d expect a really big jump, what he specified as a movement five standard deviations from the mean, once every seven thousand years. In fact, jumps of that magnitude happen in the stock market every three or four years, because investors don’t behave with any kind of statistical orderliness. They change their mind. They do stupid things. They copy each other. They panic. Fama concluded that if you charted the ups and downs of the stock market the graph would have a “fat tail,” meaning that at the upper and lower ends of the distribution there would be many more outlying events than statisticians used to modeling the physical world would have imagined.

quants

As financial securities become increasingly complex, demand has grown steadily for people who not only understand the complex mathematical models that price these securities, but who are able enhance them to generate profits and reduce risk. These individuals are known as quantitative analysts, or simply ”quants”.

Due to the challenging nature of the work, a blend of mathematics, finance and computer skills, quants are in great demand and able to command very high salaries.

Quantitative analysts design and implement complex models that allow financial firms to price and trade securities. They are employed primarily by investment banks and hedge funds, but sometimes also by commercial banks, insurance companies and management consultancies, in addition to financial software and information providers.

In the summer of 1997, Taleb predicted that hedge funds like Long Term Capital Management were headed for trouble, because they did not understand this notion of fat tails. Just a year later, L.T.C.M. sold an extraordinary number of options, because its computer models told it that the markets ought to be calming down. And what happened? The Russian government defaulted on its bonds; the markets went crazy; and in a matter of weeks L.T.C.M. was finished.

One of the former top executives of L.T.C.M. giving a lecture in which he defended the gamble that the fund had made, stated, “Look, when I drive home every night in the fall I see all these leaves scattered around the base of the trees. There is a statistical distribution that governs the way they fall, and I can be pretty accurate in figuring out what that distribution is going to be. But one day I came home and the leaves were in little piles. Does that falsify my theory that there are statistical rules governing how leaves fall? No. It was a man-made event.” In other words, the Russians, by defaulting on their bonds, did something that they were not supposed to do -- a once-in-a-lifetime, rule-breaking event.

But as Taleb justifies, that this is just the point -- in the markets, unlike in the physical universe, the rules of the game can be changed. Central banks can decide to default on government-backed securities.

Summing Up

Therefore, traders and investors alike, bear in mind the concept presented by Taleb – prepare for the future – be sure that the inevitable will occur -- the black swans will break forth unexpectedly -- and then, psychologically, turn the event to “your benefit” – and profit from the situation!

black swan

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