The Black Swan by Nassim Taleb (The Impact of the Highly Improbable)

 Just finished reading Nassim Taleb’s “The Black Swan” and I enjoyed it even more than his previous good book “Fooled by Randomness” (not that it wasn’t a good read).

Taleb defines a Black Swan is an event which:

1. Is an outlier, i.e. something not only of very low probability of occurrence but also unlikely that we wouldn’t even think of it within the realm of possibilities 2. Very high impact event, if it happens 3. After the fact we fool ourselves into thinking that it is explainable

Examples he gives include: 9/11, October 1987 market crash, collapse of the Soviet Union. To give you a flavor of his thinking, consider the following themes from his book (not exhaustive, just to whet your appetite).

He argues that we behave as if we live in world he calls Mediocristan, where we confuse the fact that “we have no evidence of possible Black Swans” with “there is evidence of no Black Swans”. In reality we live in a world he calls Extremistan, where Black Swans may be just around the corner. Mediocristan is the world of the (predictable) randomness of dice, whereas Extremistan is the (unpredictable) randomness of the Black Swan. The world of Mediocristan is the world of the physical (e.g. the distribution of people’s heights and weights) where the Gaussian (normal) distribution adequately models this world. Extremistan is the world of “unknown unknowns”, that of the Black Swans.

Another one of Taleb’s points is that luck is the great equalizer in Extremistan. It is not the world of the physical but that of political, social and weather, for example. It is the world where the average book may sell 3-10,000 copies but the top sellers sell millions, and the difference is not explainable by anything other than luck. It is a world where if you take the average wealth of a typical sample of 1000 people and if you then drop in Bill Gates (the richest man) the average would shift dramatically; this would not be the case if we would add even the fattest man in the world (say 800 lbs.), to a sample of the weights of 1000 people, the average would hardly shift. This is a world that is not adequately described by the normal distribution.

He also riles against history and historians. He argues that we are better at predicting the future than reconstructing past, so don’t believe explanation in historical books of how and why events happened. The example he gives is that if we start with an ice cube, we can predict pretty well the puddle that will result after melting. However if we start with the puddle we have no way of predicting the shape of the ice prior to melting. The he moves onto savaging the Nobel committee and Nobel Prize winners for awards on trivial, inconsequential and often flawed theories. You get the idea of the track he is on.

He then proceeds to attack the “phony portfolio theory”, all of it based on the incorrect assumption of normality. He convincingly argues that financial world is pure Extremistan, as he points to the fact that in the last 50 years, the 10 most extreme daily moves in financial markets account for 50% of returns; not a very normal/Gaussian distribution! His point is that for investors, the acceptability of the “worst case” scenario is more important than the expected outcome.

His recommended investment approach is essentially identical to Zvi Bodie’s, protect the downside and participate in the upside. Specifically he suggests that you invest 85-90% into T-bills (downside protection) and use the remaining 10-15% to invest in a portfolio of highest risk and highest return vehicles.
All in all, I recommend the book as an interesting and educational read!