Black Swans: Highly Improbable Events in the Investment World

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About those Black Swans we mentioned yesterday. We should clarify. We are borrowing the idea from Nassim Taleb’s book, “The Black Swan: The impact of the highly improbable.” It’s a thought-provoking book with a simple idea: the most important things that happen to you in life and in financial markets are those rare events with extreme impacts that you never planned for and your models never expected.

Taleb explains why he calls these events “Black Swans”:

“Before the discovery of Australia, people in the Old World were convinced that all swans were white, an unassailable belief as it seemed completely confirmed by empirical evidence…The sighting of the first black swan…illustrates a severe limitation to our learning from observations or experience and the extreme fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single (and, I am told, quite ugly), black bird.”

Taleb is right. Black swans are ugly. We see them all the time when we stroll through Albert Park. He’s also right that markets and men consistently underestimate or fail to consider altogether high-impact events, because they are so rare. In fact, statistical models deliberately exclude rare results as outliers. Taleb’s point is that all the important things that happen in your life are outliers.

“Count the significant events, the technological changes, and the changes that have taken place in our environment since you were born and compare them to what was expected before their advent. How many of them came on schedule? Look into your own personal life, to your choice of profession, say, or meeting your mate, your exile from your country of origin, the betrayals you faced, your sudden enrichment or impoverishment. How often did these things occur according to plan?”

We don’t know about you, but the most important things in our life all happened by accident. That is, we didn’t intend them. We may have seen a good opportunity when it came along. But it came along more or less by chance.

This, by the way, is why so much of what you read in the Daily Reckoning and in our paid financial services is regarded with skepticism or disdain by more traditional media. Newspapers and magazines tend to focus on what is known. Facts are safe to report on because they are not in dispute. But yesterday’s news is of no real benefit to you as an investor. What you already know can neither help nor hurt you. It’s what you don’t know that’s likely to have the biggest impact on your life, your fortune, and your sacred honour.

That is why we try and focus on Black Swans in the investment world. You can read the newspaper to find out what happened yesterday. We try to focus on the events considered so statistically improbable that no major analyst would take them seriously. Most of these Black Swans have negative consequences, like Peak Oil… or a housing crash… or the collapse of the U.S. dollar. The history of financial markets shows that high-impact events are much more probable than statistical models would indicate.

But there is also money to be made in discussing the events that unimaginative people don’t take seriously. Granted, it is hard to forecast what hasn’t happened. But that is not really the goal of making Black Swans part of your investment approach. Most big breakthroughs in science, medicine, and technology were not the result of a carefully laid five-year plan. They were fortunate and random discoveries by curious, risk-taking discoverers and entrepreneurs. We believe there’s value in that approach for investors.

Nassim Nicholas Taleb puts it this way:

“The reason free markets work is because they allow people to be lucky, thanks to aggressive trial and error, not by giving rewards or ‘incentives’ for skill. The strategy, then, is to tinker as much as possible and try to collect as many Black Swan opportunities as you can.”

Another way of putting this is that the AMPs, BHPs, and Telstras of the world may help you preserve capital you’ve already accumulated. But its oil wild-catters, the precious metals exploration outfits, and the start up alternative energy companies that will help you get the capital to begin with. You already have plenty of information and resources on how to keep money you already have. Our goal here is to help you find the positive Black Swans in the financial world. How do we do it? More on that tomorrow.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. If you think a black swan is ugly, then you have never really stopped and looked at one.

    Sadly the rest of this piece does not yield to critical analysis – too many misleading and conflicting statements. You can do better.

    Reply
  2. If life were disjointed and lacking any causal chains, the Black Swan paradigm would hold true.

    However, as a record of living, life consists of causally connected acts staged under circumstances of events. Living has us start from a foundational act and moves us through chains of building acts that lead us to change moments. At these grab-the-success moments, we rise to the challange, act and score or we do not.

    Unless we start off a chain of connected acts and unless we move through the circumstances of events, we will never reach so-called “rare events”.

    Black Swans and other false beliefs suffer from consensus supported by decrees — what some call paradigms.

    A paradigm gets inculcated into commoners by elites and get reinforced through media. A paradigm gives rise to practices of behavior — ritual, protocol, custom, inhibition, addiction, superstition, convention — and of mind set — prejudice, habit.

    The typical man (the Old English word for the French “person”) will accept paradigms told by public educators, PhDuh Darwin and Big Bang Preachers, bosses, and politicians.

    The depth of paradigm acceptance sets the degree to which a paradigm keeps a man from seeing another way, a better way to act through a causal chain of events. How well a man interprets the paradigm decides the degree to which comprehending errors lead to making mistakes. How inculcated into a paradigm a man is decides the degree to which a man ignores real world data because this data does not fit withing the paradigm.

    Turbulent times arise because new players change rules and seek to install their paradigm to keep their newly acquired power. Many do not see changes happening and reply upon their existing paradigm to play what has become a new game. Enough new winners emerge during these times who support the new rules. Yet, because they refuse to lose their old paradgim, many others become losers, those who rejected the truth that change happened.

    Stock exchanges are casinos. Through time, players must lose to the house — any randomly chosen player’s real return must be lower than the actual return from playing (“investing”) since the house takes its cut to pay financial intermediares, suppliers.

    Popular information persuades the masses into holding false beliefs by amplifying their sentiment, whether that sentiment is fearful or greedy.

    Having expectation makes a difference in whether a man tries or not, how long a man persists in the face of failing, and the way a man interacts with others. Having belief about a positive future moves a man to act and attempt to achieve, even if the likelihood of success is low.

    Profit turning requires discovery of favorable bets prior to the running of any race — when the public’s belief underestimates the metaphysical odds of true winning. A smarter man bet’s his beliefs. This man bets when he has an edge over the public. When faced with a choice of bets, the smarter man chooses the one with the highest geometric means of outcome.

    What counts is knowing the rules and topography; the taboos and paradigms of players that moves them to act or not act.

    postscript

    Oh, and Free Markets work because there exists a equal chance of a payoff to all players, not an equal payout to all players. In Free Markets, each man can amass according to his will, wit and skill. Free Markets push the greatest experiement of mixing energy, matter, ideas, beliefs, skills, wits and wills.

    Reply
  3. In the Pre-Talebian era, there was Popper and the original metaphoric interpretation of Black Swan. Still relevant maybe more so…

    http://en.wikipedia.org/wiki/Falsifiability

    Up the swanee
    August 24, 2007
    Reply

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