Black Swans

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In his book The Black Swan, published in early 2007, Nassim Nicholas Taleb discusses catastrophic events that were previously thought to be improbable (what he calls “Black Swans”), and the fallacy inherent in thinking about reality and markets as if they were games of chance (“the ludic fallacy”) whose outcomes are normally distributed (“Gaussianism”). He sounds eerily prophetic about this year’s credit crisis (though, of course, he would strenuously argue that prophecy is the last thing he would ever attempt):

[Globalization] is here, but it is not all for the good: it creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are now interrelated. So the financial ecology is swelling into gigantic incestuous, bureaucratic banks – when one falls, they all fall.

[Note: As if we did not have enough problems, banks are now more vulnerable to the Black Swan and the ludic fallacy than ever before with “scientists” among their staff taking care of exposures. The giant firm J.P. Morgan put the entire world at risk by introducing in the nineties RiskMetrics, a flawed method aiming at managing people’s risks, causing the generalized use of the ludic fallacy… (A related method called “Value-at-Risk,” which relies on the quantitative measurement of risk, has been spreading.) Likewise, the government-sponsored enterprise Fannie Mae, when viewing their risks, they seem to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events “unlikely.”]

The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur… I shiver at the thought. I rephrase here: we will have fewer but more severe crises. The rarer the event, the less we know about its odds. it means that we know less and less about the possibility of a crisis.
What does this tendency of reality to diverge from Gaussian models mean, in practice, for investors? It is apparent from the last year, as it has been made apparent many times before, that simply relying on the consensus, or average, view of the markets will not do. One has to dig much deeper than that.

How can one prepare for black swans? No method will be foolproof. Diversification is fine as far as it goes, but we have found recently that many supposedly safe, diversified portfolios have turned out to be vulnerable to the Black Swan. But it is possible that alternative research presents some ideas. Earnings quality and forensic accounting tools might have alerted investors to possible accounting issues at the GSEs. Channel checkers might have revealed leading data about auto and home sales ahead of these trends becoming official knowledge. Country and political risk experts may warn of brewing trouble in emerging markets. While none of this is guaranteed, exposing oneself to more long-tail ideas and sources can only help. If one is to have any hope of doing better than the average, one must be prepared to spend time thinking about issues that are missed by consensus ratings and forecasts.

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