Black Swan Theory
and
Its Effect on the Stock Market


Black Swans: Expecting the Unexpected!

The Impact of the Highly Improbable



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black swan theory

From Wall Street to Washington, we’re constantly being told that the future can be forecast, that the world is knowable, and that risk can be measured and managed. Nassim Nicholas Taleb is having none of this. In his new book, The Black Swan, the finance guru and author of the surprise hit “Fooled by Randomness” argues that history is dominated not by the predictable but by the highly improbable — disruptive, unforeseeable events that Taleb calls Black Swans. The effects of wars, market crashes, and radical technological innovations are magnified precisely because they confound our expectations of the universe as an orderly place.

Nassim Nicholas Taleb

Definition

The Black Swan Theory is an event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict. According to the prominent author, philosopher and NYU professor, Nassim Taleb, this type of event can be positive or negative, but deemed improbable, yet can cause massive consequences.

The theory was developed to explain:

1. The disproportionate role of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology.

2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities).

3. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs.

Therefore, to put a simpler view forward -- Identifying this type of event, based on the author's criteria and applied to today’s world, a black swan event has three attributes suggesting that:

1. The event is a surprise (to the observer).

WA -1955-unofficial cygnis

2. The event has a major impact.

3. After its first recording, the event is rationalized by hindsight, as if it could have been expected (e.g., the relevant data were available but not accounted for).

It is based on an Old World premise that black swans did not exist, because one was never seen until settlers ventured to Australia.

Picture: Western Australia unofficial cygnis

Video of Black Swan Theory

This video is about the Black Swan Theory, by Nassim Nicholas Taleb, where he explains the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations which no economist can predict. He also states that any economist that says that they can predict the future is a fraud.

Unlike the earlier philosophical "black swan problem", the "Taleb theory" refers only to unexpected events of large magnitude and consequence and their dominant role in history. Such events, considered extreme outliers, collectively play vastly larger roles than regular occurrences.

Black swan events are typically random and unexpected. For example, the previously successful hedge fund Long Term Capital Management (LTCM) was driven into the ground as a result of the ripple effect caused by the Russian government's debt default. The Russian government's default represents a typical event because none of LTCM's computer models could have predicted this event and its subsequent effects.

Black Swans, Markets and

Human Behavior

Classic events, based on Taleb's theory, include the rise of the internet and personal computer, the September 11 attacks and World War I. However, there are many other events such as floods, droughts, epidemics and so on that are either improbable or unpredictable or both. This "non-computability" of rare events is not compatible with scientific methods. The result, says Taleb, is that people develop a psychological bias and "collective blindness" to them. The very fact that such rare, but major events are by definition outliers, makes them dangerous.

Other typical events include the 1929 Stock Market Crash, the Destruction of Pompeii following the eruption of Mt. Vesuvius in 79 A.D and the Atomic Bomb on Hiroshima in 1945. They include recent events such as the U.S. Attacks on Sept 11th and the Japanese Tsunami on March 11, 2011. Black Swans are game-changers.

They can also include unpredictable slower moving events such as the Collapse of the Roman Empire. Such events depend on which side you are on as to whether you are the recipient of a black swan event.

And now we have the latest game-changer – the European debacle!

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aapl iphone

Apple Inc.’s (AAPL) successful product launch of the iphone can be perceived as a black swan for the competition, but certainly not for Apple. To some companies it had a devastating effect, and for options traders there was the opposite effect, if playing on the correct side of the track.

The same was true for the momentous

"flash crash" on May 5, 2010 which dropped 600 points in 10 minutes resulting in catastrophic losses to some. Fortunes indeed could have been made by knowing in advance the last two events.

Potential black swan events with potentially devastating effects are on the horizon. But what is the probability that they will impact you, your company or your stock market investment? Is it even worthwhile to consider these types of events, let alone perform the calculations?

black monday

Implications for Markets and Investing

Stock and other investment markets are affected substantially by all manner of events. Downturns or

market crash such as the dreadful Black Monday or the stock market crash of 1987 or the internet bubble of 2000 were relatively "model-able," but the September 11 attacks far less so. And who really expected Enron to implode? As for Bernie Madoff, one could argue either way.

But the point is, we all want to know the future, but we can't. We can model and predict some things (to an extent), but not others, not the black swan events. And this creates psychological and practical problems.

For example, even if we correctly predict some things that impact on the stock and other financial markets, such as election results and the price of oil, some other event like a natural disaster or war can override these other factors and throw our plans totally out of kilter. Furthermore, events of this kind can happen any time and last for any length of time. (Are the markets random or cyclical? It depends on who you ask.

Strategy Plan to Cope with a Black Swan Event?

What benefits can be derived by considering this type of event in your strategic plan?

How statistically significant are these outlier events?

We often hear that there are three types of people:-

1. Those that make it happen;

2. Those that let it happen, and

3. Those that don't know what happened.

It applies to black swan events in the stock market.

The action you undertake in this incidence depends greatly on what category you put yourself in!

There are risks and costs to a program of action.
But they are far less than inaction.” – JFK

Unpredictability of Past Events

To illustrate the unpredictability of these events, we'll look at past wars. On the one hand, there was the incredibly short Six Day War in 1967, but on the other hand, in 1914, people thought "the boys will be home by Christmas." In fact, those that survived at all were home four years later. As for Vietnam, that did not exactly turn out as planned either.

Conclusion

Predicting financial markets can be done, but their accuracy is as much a matter of luck and intuition as of skill and sophisticated modeling. There are just too many of these events that can happen. All manner of factors can nullify even the most complex modeling, because one just cannot include the truly unknown into the model.

unexpected events

This does not mean that modeling and prognoses cannot or should not be done. But we cannot and should not rely on them all that much. We also need to rely on intuition, common sense and simplicity. Furthermore, investment portfolios need to be made as crisis and black-swan-proof as possible. Our old friends, diversification, ongoing monitoring, rebalancing and so on, are less likely to let us down than models that are fundamentally incapable of taking everything into account. In fact, the most reliable prediction is probably that the future will continue to remain a mystery, at least in part.

There is a need to 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.

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