The Black Swan, or how to cope with the unpredictable

Arnaud Weiss
8 October 2021

Nassim Nicholas Taleb is one of those fascinatingly complex people. A Lebanese survivor of the civil war that tore the country apart, a trader and mathematician in the United States, he built his fortune by betting on highly improbable events. This money, which he describes as "Fuck you money", has enabled him to live his dream life: to become a "philosopher-slacker". But also to write essays at the crossroads of philosophy, economics and mathematics, while mocking on Twitter the researchers who publish works with approximate mathematics. A confidential author, he became very well known after the publication of Black Swan - The Power of the Unpredictable, in which he predicted the 2008 crisis. Selling millions of copies, The Times described it as one of the 12 most important books since World War II(source).

It is impossible to summarize "The Black Swan" in an article, considering its richness. I'll just share with you some of its key ideas, to make you want to read it.

In this article, discover :

- Black Swans, the extreme events that dictate our lives

- Their three key characteristics

- The consequence of their existence on our predictions

Black swans, the extreme events that dictate our lives

Taleb's central theory is that our destinies, both personal as individuals and collective as societies, are governed by events that are both extreme and improbable. These events, which he calls "Black Swans", are the main determinants of economics, geopolitics, culture... The attacks of September 11, 2001, the subprime crisis, Covid, are all unexpected bursts that have had consequences beyond the sum of all our ordinary days.

Let's take a simple illustration: J. Estrada, author of the 2007 study "Black Swans and Market Timing: How Not To Generate Alpha", examined the returns of 15 stock markets and over 160,000 daily changes. Over 107 years, the average daily return for a mutual fund is 0.02%, which is insignificant. Conversely, if this fund had avoided the 10 worst days of variation, it would have generated a 206% increase in wealth(source)! It is these extreme fluctuations, these bursts, that generate most of the variance. And this is true for many other areas. It is therefore on them that we must focus.

And yet, laments Taleb, we continue to believe in the ordinary and behave as if these extreme events do not exist. Companies make linear growth forecasts. Individuals project a smooth future. We are not mentally equipped to deal with the unexpected. Even economists grossly underestimate the occurrence of Black Swans and fail to prepare for them.

"Why didn't anyone see this coming?" the Queen of England asked economists at the London School of Economics (LSE) after the 2007 crisis (source)

The first lesson of Taleb's book is that the common, the expected, the obvious is far less important than the unexpected andthe extreme. Even among individuals!

"I have little interest in the commonplace. If you want to get an idea of a friend's character, ethics, and elegance, you have to judge him under the pressure of difficult circumstances. Not in the light of the happy days of everyday life."

The three key characteristics of a black swan

Let's dig into the notion of the Black Swan. First of all, what do swans have to do with it? The term comes from the firmly held European belief that all swans were white. The sighting of the first black swan in Australia - beyond the surprise it was for ornithologists - illustrated the great fragility of our knowledge. A single sighting invalidated a rule derived from millennia of observations of millions of white swans. All you need is a single black (and, apparently, quite ugly) bird. 

We touch on Taleb's second lesson: our knowledge is limited and fragile. His book is above all a call to humility. The theory of relativity has shattered the Newtonian theory of gravity, which is now being challenged by discoveries in quantum physics. We must be modest and adopt an empirical and sceptical approach.

Beyond the amusing anecdote, Taleb attributes three characteristics to a Black Swan event:

- It is unpredictable

- It is highly unlikely that

- It has an extreme impact

For Taleb, the corollary of these characteristics is that attempts to predict the future (stock market, economy, history...) are not science but divination. Indeed, they cannot anticipate the Black Swans, which are the drivers of structural change.

The impact of Black Swans on our predictions

For Taleb, economists and historians who attempt to make predictions are either liars or in complete denial of reality. He backs up this claim with a close examination of the projections of these experts. Taleb had fun comparing the growth predictions of the world's most renowned economists with the actual data, once the period had passed. He made three observations:

1. Experts' projections are massively wrong

2. A simple algorithm such as a linear regression based on a single variable (e.g. employment) is more accurate

3. Worse, the margins of error between experts are smaller than the margins of error with reality, which indicates a herd phenomenon.

Famed economist Larry Summers has created a graph showing the gradual decline of the Congressional Budget Office's economic growth forecasts for each of the seven years of the Great Recession. Summers' graph shows our incompetence when it comes to predicting the future.

The existence of Black Swans - and our inability to anticipate them - makes it extremely difficult to project into the future. Furthermore, most statistical models require that values that deviate too far from the mean ( outliers) be removed in order to function, whereas it is precisely these that should be looked at!

Several phenomena amplify our inability to predict. Most importantly, we overestimate our skills and understanding of the world. 94% of Swedes believe they are in the top 50% of drivers. 84% of French men believe that their sexual performance puts them in the top half of French lovers. And in fact, the less expert we are, the more we overestimate our skills (Dunning-Kruger effect). This phenomenon leads us to massively underestimate our margins of error. The consequence: the field of possibilities is reduced in our predictions, the real future event is not part of the envisaged scenarios.

Taleb's book is therefore an invitation to humility but also to distrust the experts who make projections. It could be summed up by the famous phrase of Seneca in On the brevity of life: 'The present is short, the future uncertain; the past alone is secure: for over it fortune has lost its rights'. Once this premise has been accepted, what can be done? How to make the right decisions and prepare for the unexpected? Taleb gives some keys, which I will share in the next article.

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