This article was first published in the National Business Review on 8 February 2008
A book entitled The Black Swan
by Nassim Nicholas Taleb, an American financial trader of Lebanese origin, has
a timely message, given the recent unexpected turmoil in financial markets.
Taleb sets out what he thinks has gone wrong with our attempts to
forecast events, in both finance and generally. We are wedded to the assumption
that the future is likely to resemble the present. We study past events and regularities, and
work out the probability of their recurring.
Taleb argues that instead the world is dominated by what he calls ‘Black
Swans’. A Black Swan is an event with 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.”
The sighting of black swans by European settlers in
Taleb cites two social philosophers who he thinks got things right. One is Karl Popper, best-known as the author of the anti-totalitarian study The Open Society and its Enemies. Popper’s method was not to find regularities in experience but to try to disprove hypotheses in light of the evidence.
Popper also argued that in order to predict historical events you need to predict technological innovation, itself fundamentally unpredictable. If we knew about future inventions today, we would be inventing them today, and so they would not be future inventions but present ones.
The other social philosopher was Friedrich Hayek, who stressed
uncertainty and the limits of knowledge:
“For Hayek, the true forecast is done organically by a system, not
by fiat. One single institution, say, the central planner, cannot aggregate knowledge; many important
pieces of information will be missing. But society as a whole will be able to
integrate into its functioning these multiple pieces of information. It may be more prepared for
Black Swans, and more able to cope with them when they happen, than is any one
individual.”
But Taleb has gone beyond just advocating ‘practical skepticism’; he is
‘putting his money where his mouth is’ by managing an investment fund in a way
that goes against the orthodox methods of risk management. It is to avoid what financial advisers call
‘medium risk’ and to combine being hyperconservative (in order to avoid harmful
Black Swans) and hyperaggressive (in order to catch beneficial Black
Swans). Invest most of your money – up
to 90 percent – in the safest possible way, in US Treasury bills, for example.
The rest you should invest in a highly speculative way, such as in venture
capital portfolios, spread over as many firms as possible. Alternatively, have
a highly risky portfolio but insure against possible losses of more than, say,
15 per cent.
Taleb doesn’t say how well his strategy is performing compared with
orthodox ones. And there is reason not to push his thesis too far. We surely have to conduct our lives largely
on the basis of continuing regularities. Will the sun rise tomorrow? It has
done so every morning in human experience, and it is reasonable to arrange our
lives on that assumption. The message I
take from the book is the need to be alert to the conditional nature of
assumptions based on induction.
Second, I’m not wholly convinced by Taleb’s critique of the finance
industry. Efficient market theory
predicts that the reliability of most professional financial forecasts is low,
since price movements should follow a random walk, perhaps around a trend. Yet in recent decades stockmarkets have been
reasonably stable and have performed quite well. The two main rules of thumb for investing in shares
– invest for the long term, and diversify your portfolio – seem
well-founded. Taleb's investment
strategy of combining 'hyperconservatism' and 'hyperaggression' might best be
seen as an unorthodox form of diversification, which may - or may not - prove
in the long run to be superior to more conventional forms, or be superseded by
other innovative forms.
Still, the future is uncertain and the interconnectedness of the modern
world greatly increases the reach of the unintended and unforeseeable
consequences of actions and events. If
decisions were taken by majority vote, society would be unprepared. But societies that are free and open, and in
which decision-making is as decentralised as possible, are best able to adapt
to the unexpected when it arrives.