It’s Thursday, so it’s Eddie time. He blogs at Summaticus, and in all of our hearts.
In 2007, a former derivatives trader, professor, and thinker named Nassim Nicholas Taleb wrote a book called The Black Swan: The Impact of the Highly Improbable. It is a book about an event that Taleb refers to as a Black Swan. In yesteryear, humans thought that all swans were white, as they have never seen that particular bird of a different colour. However, the conventional wisdom of all swans being white was shattered when the black variety was subsequently discovered. According to Taleb, absence of evidence is not evidence of absence.
Taleb argues that human beings are blind to the metaphorical Black Swan and are ignorant to its consequences. According to him, a Black Swan has three characteristics:
• it is an outlier, or something that lies outside the realm of regular expectations
• it carries and extreme impact
• it can be explained after the fact, but not predicted beforehand
Taleb indicts the conventional wisdom of society and the use of the bell curve. Taleb argues that outliers cannot be ignored, as humans have a tendency to underestimate both their frequency and their magnitude. Conventional wisdom teaches us that extreme outliers on the bell curve are not impactful, as they have a low probability of occurring. The world is not dictated by mundane but frequently occurring events, but by relatively infrequent but significant events. By ignoring outliers through hubris and epistemic arrogance, the world has become increasingly vulnerable to Black Swans.
For most people, 9/11 was a Black Swan. It was completely unexpected, had a profound effect on world and financial events, and can be only be explained after the fact (however, it was not a Black Swan for the terrorists who piloted the planes, who obviously knew that such an event was likely due to their participation in it). The financial crisis of 2008 was another Black Swan for the vast majority of people (but not Taleb). However, most people do not account for Black Swans and the risk of them occurring in their investment strategy, hence the amount of money that was lost during the stock market crash. It is a critical mistake to overlook these impactful events.
While this may appear to be an esoteric concept, it has profound implications for investing and personal finance. Because of our tendency to overlook Black Swans, we confuse risk and volatility. Humans have a penchant for gravitating towards variables that appear stable, but are in fact incredibly unstable. Low volatility is equated with low risk, kind of like building a house on top of a volcano. While the volcano may not have erupted in recent memory, it does not mean that there is a low risk of it erupting. For the ignorant person who builds a home on top of a volcano, the eruption could be considered a Black Swan. For those who are wise and knowledgeable enough to understand the geological and volcanic properties, the eruption is not a Black Swan.
The volcano analogy is a useful metaphor for index investing. Lauded by the personal finance community, the value of an index portfolio is susceptible to Black Swans, like the oft financial traumas of the stock market crash of 1987, the dot-com bubble, the financial meltdown of 2008. Pundits lauded “safe” investments that carried much risk, but appeared to have lower risk because of the cloak of low volatility. Index investments are incredibly sensitive to Black Swans, but are praised by the “experts” that Taleb heavily criticizes as charlatans.
My next post will focus on Black Swan Investing or what Taleb calls “Barbell Investing”. Until then, feel free to email me your thoughts at email@example.com.