Warning: The Black Swan by Nassim Taleb (is easily in my Top 5 Best Books of all time. Taleb’s mixture of insight and irreverence is a powerful combination that can be addictive (I have reread this book twice more in the last year) but it is also a very deep read. His examination of past philosophers, analysis of Wall Street risk management models, conversational writing style and over use of parenthesis are enough to make your head explode at times. With all of this considered I must admit that I have never dog-eared as many pages or underlined as many passages as I have with this book. If like Neo in the movie The Matrix you are willing to swallow the “red pill” to discover the truth about the machine world and see how far the rabbit hole will go, Taleb will absolutely blow you away by shaking your thinking to its core. Below are just three of dozens of important takeaways that I have discovered from The Black Swan.
Many observations do not a pattern make.
Before the “discovery” of the Australian continent, the rest of the world only “knew” that swans were white because every observation up to that point had confirmed the fact that they were white. The instant that the first black swan was observed that “fact” changed forever because there were now examples of swans that were indeed black. Taleb uses the black swan story as an example to help show us how much we rely on learning from observations and how easily we fall victim to our instincts based on these “limited” observations. A more modern example that is also easy to remember would be the Thanksgiving turkey. The turkey has a wonderful life where he gets fed and loved every day… right up until that last the day when he is butchered and served at the Thanksgiving Day feast. The turkey thought he knew how the world worked, he had many daily observations and those observations had very little deviation from his understanding of a “normal” day that would have ever led him to believe that that the world was different. Then one day all of that changed. The same is true for many things in our daily world; some things follow a natural order of the world like the laws of gravity but some don’t (our collective belief prior to 2006 that home prices will continue to increase) and when things behave as we wouldn’t have predicted they can have significant impacts on our “normal” lives like the economic troubles that have dominated the last five years. Taleb warns us that we need to be mindful of these “normal” assumptions whether through our own decision making or we are lead to believe them from supposed experts.
Beware of alluring power of averages.
Taleb creates two worlds to help categorize the difference in these events. In the world Mediocristan events follow the laws of nature and gravity. With distributions of weight we all fall around an average (195.3 lbs for men in the United States) and while that average seems to be going up it is physically impossible to have a man that weighs 3000 lbs (note: the heaviest man ever recorded did weight 1400 lbs). Note the average may go up or down but the impact of a 1400 lb man will not impact the average weight of all men. To differentiate from this world that is bound by gravity, Taleb defines the world of Extremistan where inequities of so large that one wild observation can greatly impact the average. Wealth, book sales, and stock prices are all examples that belong in Extremistan where a single “outlier” can have a dramatic impact on the average. It is in this world of Extremistan that black swans occur because they are not held down by the laws of gravity. The collapse of Lehman Brothers is a perfect example of where building your investment strategy on the “averages” of the past can be at your own peril. The changes in market volatility due to the implosion of subprime mortgage bonds caused Lehman’s trading strategy to become flawed and exposed the 158 year old bank to financial risks that they hadn’t anticipated and ending in their ultimate bankruptcy. They counted on the averages and they averages were simply wrong.
Managing risk in financial markets is a farce.
Taleb loves to call out the frequent failures of Wall Street over the last couple of decades: Long-Term Capital Management, Bear Stearns, Lehman Brothers, and most recently the often cited paragon of strong financial risk management JP Morgan Chase. These banks all hired some of the smartest mathematicians in the world, they all used the prescribed models for managing risk and they were all blindsided by black swans that cost them billions of dollars in losses and except for JP Morgan Chase it ultimately cost them their companies. The analytical tools that were supposed to save them from ruin could not comprehend and incorporate the impact of a black swan and thus offered them no protection at all. Many retort that these are the best tools possible and suggest that we should continue to use them since we have nothing else. Taleb thinks otherwise and suggests that by pretending that we can “manage” risk we are actually creating more harm than good through unnecessary losses. He further suggests that if you are worried about the stability of your financial investments that you should have 85% of your portfolio in very safe treasury bills and use the remaining 15% to take risky investments that will payoff when the next black swan happens – and while extremely cautious about making “predictions” he is certain that there will be a next black swan.
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