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January 14, 2008

Nick Taleb's 'The Black Swan' Rules


Just in via Pablo Triana's article in today's Financial Times, the news that my friend* Nassim Nicholas Taleb ended 2007 as Amazon.com's bestselling author in the non-fiction book category with his mega-hit, "The Black Swan."

You could look it up — or just glance at the graphic above if you don't have the time, being the busy and important person you are.

Full disclosure: I received the galleys of "The Black Swan" months in advance of publication but even with that heads-up still wasn't smart enough to figure out how to apply Nick's insights and actually make money in the market.

I guess that's why he's rich and retired and writing bestsellers while I'm still passing gas and producing this virtual rag.

But I digress.

Here's the Financial Times story.

    Beware of the 'black swan' effect

    Nassim Taleb's bestseller has had a salutary effect on investors' awareness of risk

    The veteran options trader (and indefatigable sceptic intellectual) Nassim Taleb has ended 2007 as the top bestselling author in the non-fiction book category, according to Amazon.com. Mr Taleb’s "The Black Swan" crowns his outrageously successful transition from market player to popular muser.

    As is well known, the book deals with unexpected, rare events that have a profound effect when they eventually take place. Mr Taleb’s main assertion is that we tend to misunderstand such events, and stubbornly assign small (even negligible) probabilities to them. In real life, “black swans” happen much more often than generally assumed. This is particularly true in the world of finance, where events that are assigned probabilities of one in 1m years make a semi-regular appearance every half-decade or so.

    Mr Taleb’s musings have not been too well received within finance theory circles. He strikes at the very foundations of financial economics, hitting out at modern portfolio theory, the Black-Scholes option pricing model and financial econometrics — three essential building blocks of academic thought (and all Nobel-endowed constructs). In Mr Taleb’s view, financial theory is not only essentially useless but also quite dangerous, as it provides a faulty guide and forces people to take actions that may result in enhanced, not reduced, market turmoil.

    But bothered as the most dogmatic of academics surely are, perhaps it is the practitioners who are most discomfited by Mr Taleb’s message. This may seem an odd assertion. After all, Mr Taleb has been one of them, and a prominent one at that. Bluntly stated, Mr Taleb’s ruminations threaten to disrupt a traditional, cherished resource at the disposal of bankers and market punters. Post-Taleb, it could become more difficult to use the “unforeseeable once-in-a-lifetime rare event” excuse for blow-up losses, just as it could become less feasible to peddle products that are heavily (negatively) exposed to the “black swan”.

    Financial dealers make a lot of money by selling and arranging sophisticated devices that can deliver nice returns for end-users as long as markets don’t turn awry. Collateralised debt obligations (CDOs) are the most recent example. For these dealers it is essential that the probability of the nasty scenario remains downplayed. After all, not many customers (not even the most reckless) would enter into a transaction where they face large odds of suffering a bloodbath. So, while (honest) bankers would tend to warn of the potential risks, it certainly helps if no one loudly proclaims that the chances of those risks materialising are far greater than negligible. By doing just that from his highly visible Black Swan parapet, Mr Taleb could be damaging many a salesman’s prospects.

    The same logic would apply to hedge funds. Many of these high-profile players enjoy nothing more than taking positions that bet on the negative black swan (the crash, the meltdown, the defaults) not taking place. For instance, many punters seem to have traditionally been avid option-sellers, a great way to generate tasty returns (in real-income form, to boot), but of course also a window to a potential devastating blow-up. Here it is again crucial to downplay the possibility of disaster.

    The black swan must be presented and marketed as undeniably unlikely, perhaps by relentlessly asserting that markets behave normally (fund managers could present tons of academic “scientific backing” in this regard). These days, however, such presentations become less convincing, courtesy of Mr Taleb’s incessant contrarian rooftop chatting. Equally likely to lose credibility becomes the traditional “unpredictable freaky rarity” excuse when faced with outlandish setbacks. So it turns out that Mr Taleb not only has achieved worldwide notoriety and fortune by transforming himself into a crack intellectual, but may also influence the way market participants interact with each other. This could be a good thing.

    By acting as “probabilistic cop” Mr Taleb could force professionals to be more honest with others and, crucially, with themselves. This applies particularly to customers and investors. The subprime mortgage crisis has allowed us to witness disgruntled members of those two factions claim their ignorance of the risks of the stuff they took exposure to, in a scenario reminiscent of past debacles. After Taleb, this could change.

    When a book that unremittingly states nasty “unexpected” high impact surprises happen quite often becomes a bestseller, it becomes much harder not to take a close look at the rarities lurking in the fat tails of the distribution, and to accept and condone claims of naive ignorance after the fact.


Hey, I'm not crying just 'cause I can't apply Nick's theories to finance.

They're equally — if not more — applicable to the rest of the great world and everyday life.

Read the book — it'll be the best $16.17 you ever spent.

If you find this not to be the case, well, not to worry.

As always, the bookofjoe guarantee applies, to wit: simply notify me of your dissatisfaction and I will refund every red cent you paid.

That goes double if you checked it out of the library.



an excerpt from Nick's website.

January 14, 2008 at 04:01 PM | Permalink


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The central ideas presented in "The Black Swan" are of the utmost significance. Our difficulty in embracing new ideas is discussed in the book as well. The presentation is narrative with interlaced stories. I found it quite intriguing the first time through it - I couldn't wait to read the next page. I'm now re-reading it, but this time my pace is much slower - I set the book aside to savor and think about each idea as I encounter it. The book is rich with ideas and insights.

One of the graphs in the books shows the S&P 500 for the last 50 years overlaid on the same with the 10 largest single-day moves deleted. The second is almost _half_ the first. In other words, 10 days' provided most of the stock market gains over a 50 year period. You can't predict that behavior with any model whatsoever, much less with the Gaussian statistical models of modern economics. Taleb's criticisms of "nerd" economics is dead on point.

Taleb does discuss specifically how to minimize your exposure to negative black swans and maximize exposure to positive black swans. In particular when investing, he suggests putting most of your money into very conservative instruments and investing a fraction (say 10%) in extremely high-risk but high payoff ventures such as biotech.

Posted by: tndal | Jul 12, 2008 2:45:05 AM

I found "The Black Swan" overrated. Talib basically repeated a few basic assertions over and over interspersed with some whining about how nobody else seems to get it. The core idea is simple: we tend to assume the world will fit simple, predictable models, but it often doesn't, much to our detriment. The core ideas are worth attention and are most likely true, but Talib seems to think repetitiveness would make up for limited supporting data, insufficient argument, and the absence of useful advice for how to apply the concept.

Posted by: K | Jan 14, 2008 5:58:29 PM

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