The Probable Black Swan

Before Australia was discovered, Europeans thought that all swans were white. “That’s as likely as seeing a black swan” was a commonplace utterance, based on the fact all the swans seen by Europeans at that time were white, leading them to assume swans everywhere were therefore white.

So black swans, according to author Nassim Nicholas Taleb are events that seem to be highly improbable but which have huge impact.

Examples could be the success of the Harry Potter books, 9/11 and of the collapse of apparently secure organisations such as Bear Stearns or Northern Rock.

Statistically, they are considered outliers and Taleb’s provocative thesis is that occurrence of these events are now far more common than normally supposed and that we normally try to rationalise or ignore them.

In his latest book, The Black Swan: the impact of the highly improbable, Taleb looks at various fallacies surrounding black swan events and the failure of much conventional thinking, particularly in areas such as statistics and investment theory, to cope with extreme events and their implications.

Indeed, Taleb calls the bell curve of normal distribution a great intellectual fraud. As his book then goes on to say, this makes modern portfolio theory, based on the concept of normal distribution, a lot of hot air.

So it was interesting to hear Taleb, a former trader on Wall Street, address an audience of investment professionals, particularly as some of them majored in areas, such as quantitative investing, that he considers to be bogus.

His advice to investment experts based on his books (Taleb has also written Fooled By Randomness)?

Firstly, Sharpe ratios, a measure of investment skill, and standard deviations do not work; don’t mistake volatility for risk, Taleb warns.

These measures were described as approximating risk in the same way that a plant approximates a human. Secondly, more diversification is needed than before, to reduce the impact of extreme events.

Other lessons are that derivatives, particularly on the short side, exacerbate the impact of small mistakes and should be used with care and that thorough stress-testing is needed, though not by the value at risk measurement.

Portfolios should be made as robust as possible to survive seemingly rare events; investors should consider what impact could events in the long tails of a distribution curve could have.

On one side their effects could be disastrously bad, while the other tail, outliers could have a dramatic positive impact.

A final thought was to have a high proportion of assets in no-risk securities, with a small proportion exposed to the maximum possible risk.

At present, Taleb is considered a maverick or dissident by academics espousing investment orthodoxy.

But his ideas are certainly worth investigating; they are thought-provoking and are undeniably set in the real world, as opposed to the assumed world of economic theory.