Wednesday, 31 March 2010

Black Swan Events/Worksheet

Nassim Taleb's The Black Swan (2007)puts forward the theory that the most important events are usually impossible to predict. The title refers to the fact that all swans were believed to be white - until a black one was discovered.

This unpredictability is particularly important in relation to finance. A trader can calculate what he thinks is likely to happen in the market, taking into account known contingencies. What can't be predicted is what Donald Rumsfeld called - 'the unknown unknowns',

Taleb puts it like this

The events that impact on our lives most are impossible to predict. After they occur we find rationalisations for them but we should accept that random events may disrupt any model or plan.

What we call here a Black Swan is an event with the following three attributes.

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. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.... 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.

Taleb's idea seemed to be spectacularly realised in the financial crisis of 2008. But what could be done to avoid such a catastrophe in the future? Taleb makes these suggestions

What is fragile should break early while it is still small. Nothing should ever become too big to fail.

No socialisation of losses and privatisation of gains.

People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

Do not let someone making an "incentive" bonus manage a nuclear plant – or your financial risks.

Counter-balance complexity with simplicity.

Do not give children sticks of dynamite, even if they come with a warning.

Only Ponzi schemes should depend on confidence. Governments should never need to "restore confidence".

Do not give an addict more drugs if he has withdrawal pains.

Citizens should not depend on financial assets or fallible "expert" advice for their retirement.

Make an omelette with the broken eggs.

Arguments against Black Swan approach
- markets may react with what Greenspan called 'irrational exuberance' but eventually correct themselves.
- Avoiding risk may also involve losing in the long run. Markets fall and then rise again (60% since September 2008)
- Some risks are unavoidable - terrorist attack, for example. All we can do it reduce them.
- the rejection of the need for 'confidence' is problematic. Is Taleb suggesting that the world economy is so inherently unstable that all investment in it is too risky?

Vocabulary - Ponzi scheme
Named after a famous fraud in which investors money was never actually invested but used to pay limited returns to other investors. Everything works fine until investors start trying to withdraw their money.
Fallible makes mistakes.

Worksheet: 50 minute activity based on Black Swan Theory

Black Swan

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