Wednesday, July 18, 2012

183. The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb

Nassim Nicholas Taleb's The Black Swan: The Impact of the Highly Improbable* (Random House, 2007; 444) is a revolutionary book that spares no word to describe how nonsense the tools of probability are in forecasting the most important events in the world today like the Financial Crisis, the advent of computers and many such events which all exist in extremistan. Nassim Taleb divides the environs within which events occur into two: mediocristan and extremistan. Mediocristan is where the usual rise and fall occurs. Events that occur in the world of extremistan are somewhat predictable and so their impact has less consequences. For instance, the population of a country in the year n+1 could be pretty well predicted; however, that a plane will fall from the skies and decimate a whole village is wholly unpredictable and these events have large consequences. A simple example given by Taleb is the 2008 Financial Crisis, something he wrote about even before it occurred. None of the highly-paid, Harvard-trained, navy-blue-suited Risk Analysts, vested in the mathematics of derivatives, could predict it leading to the collapse of large banks.

What Taleb is saying is that these tools we depend upon are helpless when it comes to the big things that matter. The invention of computer that changed the world was never predicted by anyone until it was invented. In fact, it's impact was never until today. Extremistan events are the five percent we leave out when we draw our 95% Confidence Interval using the Gaussian distribution. This Gaussian Distribution or the Normal Curve as it is widely known has assumed that events follow a pattern and that once an event falls outside that pattern it becomes an outlier. Yet these outliers, which according to Taleb exists solely in Extremistan, are those that shape the world. A backward glance through history is prove of this. However, because humans love to ascribe reasons and explain after the fact, we are likely to read reasons of their occurrence. The Black Death was never predicted but neatly explained.

Taleb defines a Black Swan event as 'an event, positive or negative, that is deemed improbable yet causes massive consequences.' The author-philosopher explained the three attributes of a Black Swan: 'First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact (unlike the bird). Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after after the fact, making it explainable and predictable.' (page xxii). The author continued 'A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives. Ever since we left the Pleistocene, some ten millennia ago, the effect of these Black Swans has been increasing.' However, accessibility to information could make a difference in Black Swan events. Thus an event could be a Black Swan to one person and an entirely White Swan (predictable) to another. Take an instance (this was used in the book) of a farmer who feeds a turkey for 999 days and kill the turkey on the 1000th day. Anyone who observes the first 999 days cannot possibly predict that the life of the turkey will end on the 1000th day. In fact, to the turkey death is a Black Swan but not to the farmer.

According to Taleb there is this kind of epistemic arrogance with men. When man comes into contact with a piece of knowledge, he behaves as if he knows everything and so could predict everything. In fact, Malthus predicted that population growth will be higher than food production leading to catastrophe. To Malthus, the invention of fertiliser and the coming of the green revolution was a Black Swan event. Most human inventions has arrived serendipitously including the two main ones in twenty-first century: mobile phones (communication) and computers. Almost every forecast about what the future will be like has been wrong because past events, which is what forecasters depend and what statisticians love most, do not account for the sudden discovery of an innovation that will totally change the course of events. History is replete with those who have been fooled by randomness. 

Taleb's thoughts are revolutionary and will make you think of markets and trade and forecasts in a different way. It makes nonsense of the economics establishment that is so fond of their Econometrics and forecasting tools of Probability. How then could one prepare himself against Black Swan events? Knowing there is a probable Black Swan in an area is good enough to protect yourself. This is a man who benefitted greatly from his postulates during 2008 Financial Crisis. And he knows what he is talking about. Above all he doesn't make the book too academic. There are directions for those not articulate in the mechanics to skip certain chapters. The chapters flow from reader-friendly basic English to more academese and other subject jargons. His views are gradually been accepted by the guardians of the academic establishment who are the hardest hit by them. People who criticised him had come to accept his theories and those who still throw arrows at him do so from arrogance and pride that academic miseducation breeds. In fact he is now mostly in demand by NASA and co.

In effect, I am telling you - whether you love economics or not, whether you are a student of that amorphous subject called statistics or not - to read this. It is that important. And it will change your thinking. Highly recommended. In the end
The Black Swan is about consequential epistemic limitations, both psychological (hubris and biases) and philosophical (mathematical) limits to knowledge, both individual and collective. I say "consequential" because the focus is on impactful rare events, as our knowledge, both empirical and theoretical, breaks down with those - the more remote the events, the less we can forecast them, yet they are the most impactful. So The Black Swan is about human error in some domains, swelled by a long tradition of scientism and a plethora of information that fuels confidence without increasing knowledge.' (Page 330) .... [F]rom this definition, we can see that it [The Black Swan] is not about some objectively defined phenomenon like rain or a car crash - it is simply something that was not expected by a particular observer. (Page 339)
Nassim Taleb is the author of Fooled by Randomness (2001) and The Bed of Procrustes (2010)
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*This is the Second Edition which had a new section: On Robustness and Fragility.

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