What swans can tell us about markets

The Black Swan: The Impact of The Highly Improbable, a new book by Nassim Nicholas Taleb, provides a timely and highly entertaining warning against the hubris of prediction

What's a 'black swan'?

An unexpected but massively significant event or phenomenon which was unpredictable before it happened and which therefore exposes the limits and dangers of learning from experience. Until the 18th century, no one had seen a swan that was anything other than white. To swan-watchers, then, whiteness was an intrinsic part of swan-ness unremarked and unquestioned. But then mutant black swans were spotted in Australia, and in an instant observers had to change radically their understanding of what it is to be a swan. Similarly, in life, all our understanding of how the world works is periodically overthrown by utterly unforeseen events the invention of the wheel, Pompeii, the crash of October 1987, Google, the Asian tsunami, 9/11. In Taleb's terms, all these are Black Swans.

Who is Taleb?

He's an ex Wall Street options trader, originally from Lebanon, who is now professor of the sciences of uncertainty at the University of Massachusetts. Just after the 9/11 atrocities in 2001, he had a surprise hit with his first book Fooled by Randomness, a witty take on stockmarket investment. In it, Taleb the inspiration for Donald Rumsfeld's famous unknown unknowns' remarks argues that predictions are worthless since markets have no memory and no one knows where prices are heading. He castigates our tendency to find false patterns and attribute causes to processes that are random, and has great fun mocking experts' who come up with specious explanations for market shocks after the event. In his new book, Taleb develops this theme: expecting the unexpected the Black Swan, he says, is the key to understanding not just markets but all history.

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What's his argument?

In a nutshell, Taleb argues that humans are hard wired' to see the world through the lens of the Platonic fallacy.' We look for structure where there is none and comprehension where none is possible. Such people are condemed to live in the realm of Mediocristan'. There, their understanding will be conditioned by "Platonified economists with their phoney bell-curve-based equations". More, they will constantly fool themselves with the "narrative fallacy" the human drive to impose a post hoc explanation on even the most shocking events. By contrast, you can choose to live in Extremistan'. There, you will understand that "societies do not crawl, they make jumps. They go from fracture to fracture." Do not be misled by the bell-curve' thinking of so-called experts, says Taleb. It limits expectations. Instead, embrace the fractal geometry of Benoit Mandelbrot where tiny events can have gigantic effects. Think big, take risks, and expect the unexpected.

Quite ambitious thinking then?

Taleb is nothing if not confident, and his book is certainly entertaining. But sometimes his iconoclasm tips over into something less attractive. The Black Swan has received warm reviews, but Taleb has been criticised in The New York Times for ridiculing his targets in personal terms while presenting himself as a renegade genius. He presents his ideas about unpredictability and luck as breakthrough concepts, while failing fully to acknowledge his many intellectual debts to the likes of Karl Popper (also George Soros's intellectual hero). And in extending his Black Swan theory to the whole of history, Taleb overgeneralises for example, he states, wrongly, that no social scientist predicted the collapse of the Soviet Union and may well be stretching his ideas past their breaking point.

What are we to make of this theory?

Taleb's contribution is valuable for two reasons. First when it comes to understanding the limits of financial modelling, and second in thinking about the macroeconomic environment. Taleb might be rudely dismissive of, say, Harry Markowitz, whose doctoral dissertation in the 1950s became the basis of portfolio theory and eventually won him the Nobel prize.

But Taleb is certainly right to caution against the complacency that sophisticated risk-management systems induce. The data used in these are necessarily drawn from a period when the institution did not experience the problems the risk models anticipate (when the bank did not go bust for example). And what of the black swan event? It is not in the risk model but that doesn't mean it's not going to happen. The bank could still go under, just not for reasons anyone has thought of yet.

How can investors make use of all this?

Currently, there are clear global risk factors: rising interest rates, the renewed threat of inflation, the slowing US economy, geopolitical instability. And yet global stockmarkets glide serenely higher. Clearly, investors believe that markets will ride out any short-term problems and believe they have factored in all the risks. But Black Swan thinking tells us to expect the unexpected.

On Friday 16 October 1987, no one had an inkling that the Dow Jones would lose over 22% of its value the following Monday. According to analysis of the Dow Jones index's historic movements by Taleb's mathematical inspiration Benoit Mandelbrot, extreme price swings should be seen as the norm in financial markets rather than as aberations. The fact that investors can see only white swans does not mean that a black swan is not around the next bend in the river. "A sound trading strategy would build this cold, hard fact into its foundations."