Black Swan Lurking

In the spirit of this column’s focus on broadening our conventional thinking, we draw upon the wisdom of turkeys and the existence of swans, specifically black swans.  What this has to do with the capital markets is detailed in the thought-provoking financial bestseller, The Black Swan – The Impact of the Highly Improbable, by Nassim Nicholas Taleb.

Taleb uses the term black swan as a metaphor for an event that is extremely rare, predictable only in retrospect, and of enormous impact.  The literal interpretation stems from a long-held belief that all swans were white.   The single sighting of a black swan in Australia, however, invalidated this truism.  Taleb expands on this principle to underscore the fallacy of building rules and drawing conclusions based solely upon what we know or observe.  He reinforces this point in the illustration below:

“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race…On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”

Modern day examples of black swans, according to Taleb, include 9/11, the market crash, the discovery of penicillin and Harry Potter book sales.  These events were not only improbable, but by definition, not previously contemplated.  Still, the human mind is wired to view the world with a sense of order and control (absent luck and randomness) and in their aftermath, there will always be coherent explanations to rationalize how these events could have been anticipated.

Taleb holds that improbable events happen far more frequently than explained by accepted statistical models.  As such, he contends that the standard “bell curve” way of looking at the world (allowing us to measure the frequency of high and low probability events) is misguided.  The implication of this natural tendency to project patterns and order where none exists is the risk of being blindsided too often by reality.

Relevant to current markets, sophisticated risk management models based on historic probabilities may, in fact, exacerbate risk by engendering false confidence. The recent sub-prime debacle is a good example where excess speculation by hedge funds resulted in severe losses because their risk models did not contemplate an unexpected liquidity squeeze, causing multiple hedge funds to unwind similarly leveraged bets, all at the same time.

In this case, it would be fair to say that hedge fund managers were guilty of overconfidence – one of the cognitive biases discussed in our column last quarter, Why Investors Make Poor Decisions.  This and other mental shortcuts that simplify decision-making and revolve around our own experiences may leave us more vulnerable to black swans.   While offering no insulation to rare events, a disciplined value-oriented approach to investing is helpful in avoiding some of the pitfalls in irrational behavior.

Not surprisingly, Taleb does not offer a prescription to become better predictors, and looking under rocks for the next black swan would be like looking for an imaginary needle in a haystack.  Taleb is particularly (and appropriately) unkind to economists and Wall Street forecasters who he says “continue to make predictions, as if they were good at it.”

We agree that our time is better spent accepting our shortcomings here and thinking more about the consequences.  History shows the world is more random than we’d like to believe and what we don’t know is often as important as what we do know.  Whether this understanding would have served the turkey any better is doubtful, but in our case, we have the opportunity to learn from experience, especially those we never imagined.