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“Black swan” event, lies outside regular expectations, and has an extreme impact

Posted by gasweek on 18 September, 2007

Nassim Nicholas Taleb in his book The Black Swan (Random House, 2007) explains how a “black swan” event lies outside regular expectations and has an extreme impact, according to Leon Gettler in The Age (5/9/2007, p.14). Taleb, a former trader who worked in quants – the funds that use complex and sophisticated mathematical algorithms to search for anomalies and non-obvious patterns in markets – is taking a break and working in the sciences of uncertainty at the University of Massachusetts.

“Unknown unknowns”: According to Taleb, people concoct explanations after the event to make it seem predictable and explicable in hindsight. The September 11, 2001, terrorist attacks and the unpredicted rise of Google are just two examples of black swans, the kind of events that former US defence secretary Donald Rumsfeld called “unknown unknowns”.

The tale of the first black swan: Taleb borrowe the term from the impact of the sighting of the first black swans in Australia. Before the discovery of Australia, people in the Old World were convinced that all swans were white and justifiably so, as all the empirical evidence supported that belief. Then, in 1696, Dutch navigator Willem de Vlamingh became the first European to sail up Perth’s famous river and discovered that not all swans were white. One single observa­tion invalidated all assumptions.

Nobel Prizes in mathematics not enough: A good example is the collapse of Long Term Capital Management in 1998. Put together by people with Nobel Prizes in mathematics who were considered to be geniuses, LTCM went broke and nearly brought down the financial system when its models, which ruled out the possibility of large deviations and took on a mon­strous amount of risk, failed to take into account the black swan of the Russian debt default.

Why you need eccentrics: The problem with experts, says Taleb, was that they do not know what they do not know and they were no good at predicting the irregular. Taleb divides the world into two:

Mediocristan: made up of more or less of predictable events that do not have too big an impact, and

Extremistan: where most of the black swan action is. One of our short­comings, says Taleb, is that when a black swan event passes into history, we start predicting it will happen again, when in fact the odds of it recurring have been lowered. New York was a lot safer on September 12, 2001, than it was the day before. Still, the tendency to overestimate explains why insurance is such a cracker business. Also, abstract statistical infor­mation has less pull on us than anecdotes and compelling and terrible tales. Terrorism kills, but more people die every year from environmental disasters. Yet we overestimate the likelihood of another terrorist attack.

The Age, 5/9/2007, p. 14

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