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I just finished reading The Black Swan by Nassim Nicholas Taleb. The title of the book comes from the observations of Europeans that all swans are white. Much to their surprise, they came to Australia and found their first black swan. The book starts with this story to illustrate the “limitations to our learning from observations or experience and the fragility of our knowledge.” As Taleb points out, it very different to think there is evidence of no possible black swans, than there is no evidence of the possibility of black swans.
Taleb has received lots of press and admirers given the recent meltdown in the financial markets. The book was published in 2007. Taleb seems to have perceived the coming collapse (and probably got a rich financial reward based on his strategy).
His supreme self-confidence (arrogance) shines brightly through in his writing. He has little time for shallow thinking and those who think they understand risk or the financial markets.
Another example running through the book is the first 1,001 days of a turkey’s life. For a 1,000 days the farmer brings food to the turkey every morning. On that last day, things change dramatically. The farmer shows up with an axe instead of food. A surprise and horrible change in circumstance for the turkey. But all the historical evidence for the turkey indicated that the farmer would show up with food and not an axe. Of course, on the flip side, the farmer saw the axe day coming.
As Yogi Berra philosophized: “It’s tough to make predictions, especially about the future.”
It is the unknown unknown that is most dangerous. We spend too much time focusing on knowing what we know. We need to spend focusing some energy in realizing what we do not know and what we do not know what we do not know.
As a compliance and risk professional I was particularly intrigued by the story of the four largest losses by casinos. As you might expect, casinos run very thorough security programs, compliance programs and risk management programs. The four largest losses fell completely outside the casinos’ models. One was the white tiger’s attack on Roy, the second was a disgruntled contractor who attempted to dynamite the casino, the third was the kidnapped daughter of a casino owner, and the fourth an incompetent employee who failed to file the 1099 reports with the Internal Revenue Service.
It is also important to draw the distinction between positive contingencies and negative contingencies. The black swan can be one that brings unexpected destruction or one that brings an unexpected windfall. His philosophy is to play it safe, but hedge for a disastrous losses and spectacular windfalls. Mitigate the unexpected consequences.
I expected to get a lot of insight from the book. But it was one of the few books that changed the outlook on my profession.
This is a lot more interesting than I expected.
Not knowing the unknown, how can one “mitigate unexpected results” or have a distinction, between what could lead to moderate vs disastrous losses? If we don’t know what we don’t know, then could we have an objective perspective – any perspective? How can a turkey ‘forecast’ an axe coming?
I am wondering if we are seeing a continuum of analysis here:
First Freakconomics highlighting causation and correlation, so what you think is the cause may not be necessarily it; then Tipping point with epidemics and butterfly effect, and now – the unknown of the unknown?
Does this mean that in order to have better understanding (is it possible?) we need to analyze situations to flesh-out the tiniest detail and to include every possible scenario, from food through a new turkey-mate and to an axe? It kind of reminds me Actor Network Theory, an information systems theory that claims that in order to implement a successful system, all ‘actors’ involved (people, computers, location, environment, etc) needs to be considered, which is rather impossible, as the analysis never ends, really, as each ‘actor’ is impacted by another actor which needs to be analyzed. The philosophy is totally different, but the question of how can you know what to analyze, and how deep you need to dig, to me is very similar in both theories, and is beautiful and scary at the same level.
Alin –
I did see a common theme between Freakonomics and The Black Swan (I have not read Tipping Point yet). Both advocate challenging your assumptions. The world may not be working in the way you think. The data points could mean something different. Or you may not have all the data.
There are also some similarities with the Actor Network Theory. There are so many variables and things that can affect the outcome that you cannot measure them all. Even if you are right 99% of the time, you are still going to be wrong 1% of the time.
Taleb points out that you need to address what happens with 1%. Is it a windfall or a harsh loss?
He does not advocate not trying. You need to try to control and forecast the best you can. But you also need to expect the unexpected.
Taleb also has a radical financial investment strategy. He puts 85-90% of the capital in Treasuries with the rest in positions that take pay off with big swings in the market, up or down. Effectively he gets little current return and occasional huge payoff. He calls most investment strategies: picking up nickels in front of an oncoming bus.
I am still digesting how Taleb’s theories fit into my views on compliance. More will come on that. In the meantime, you may want to read this article that was in the New York Times last month: Risk Management. There are a few paragraphs on Taleb and The Black Swan.