Nassim Nicholas Taleb popularized the notion of black swan occurrences in his book The Black Swan: The Impact Of The Highly Improbable (Penguin, 2008).The crux of his work is that infrequent and difficult-to-predict occurrences have a significant impact on the globe. The ramifications for markets and investments are strong and should not be overlooked.
- Black swans are exceedingly unusual occurrences that often have serious implications.
- A black swan occurrence cannot be foreseen in advance, although it may seem clear in retrospect.
- Standard forecasting methods and investment models might fail to foresee and perhaps enhance exposure to black swans by spreading risk and providing false security.
Black Swans, Markets, and Human Behavior
A black swan is an unexpected incident that goes beyond what is generally anticipated of a situation and may have serious implications. Black swan occurrences are distinguished by their great rarity, terrible effect, and universal belief that they were evident in retrospect.
Taleb describes a black swan as an event that:
- is so uncommon that even the likelihood of its occurrence is unknown;
- When it happens, it has a disastrous effect; and
- is described in retrospect as if it were foreseeable
Taleb contends that for very uncommon occurrences, typical methods of probability and prediction, such as the normal distribution, do not apply since they rely on a huge population and prior sample sizes that are never accessible for rare events by definition. Extrapolating, or utilizing statistics based on previous occurrences, is not useful for forecasting black swans, and may potentially make us more susceptible to them.
The emergence of the internet and personal computers, the September 11th attacks, and World War I are all examples of classic black swan occurrences. Many other phenomena, however, such as floods, droughts, and epidemics, are either unlikely, unexpected, or both. As a consequence, individuals acquire a psychological predisposition and “collective blindness” to them, according to Taleb. Because such infrequent but significant occurrences are by definition outliers, they are risky.
Implications for Markets and Investing
All forms of events have an impact on the stock and other financial markets. Black Monday, the 1987 stock market meltdown, and the dotcom boom of 2000 were all reasonably “model-able,” while the Sept. 11 attacks and the COVI19 pandemic were not. And who could have predicted Enron’s demise at the time? One may claim that there were red signals in the Bernie Madoff Ponzi scam.
The idea is that we all want to know what will happen in the future, but we can’t. We can model and forecast certain things, but not black swan occurrences, which cause psychological and practical issues.
Even if we properly foresee certain variables that affect the stock and other financial markets, such as election outcomes and oil prices, other occurrences, such as a natural catastrophe or war, might overwhelm the predictable elements and throw our plans completely off kilter. Furthermore, such occurrences may occur at any moment and for any length of time.
Consider two previous conflicts as examples. In 1967, there was the very brief Six Day War. When World War I began in 1914, everyone expected “the lads to be home by Christmas,” but those who survived did not come home for four years. Vietnam, on the other hand, did not go as planned.
Complex Models May Be Pointless
Gerd Gigerenzer also contributes some valuable information. He claims in his book, Gut Feelings: The Intelligence Of The Unconscious (Penguin 2008), that 50% or more of judgments are intuitive, but individuals generally avoid employing them since they are difficult to defend. People instead make “safer,” more conservative choices. As a result, fund managers may refrain from suggesting or making riskier investments merely because it is simpler to go with the flow.
This also occurs in medicine. Doctors cling to tried-and-true therapies, even though lateral thinking, ingenuity, and sensible risk-taking can be suitable in a given situation.
Complex models, such as Pareto efficiency, are often inferior to intuition. Because such models only operate in limited circumstances, the human brain is often more effective. More knowledge does not always assist, and obtaining it may be costly and time-consuming. A laboratory setting is extremely different, yet complexity may be managed and controlled in investment.
In contrast, merely ignoring the possibility of black swan occurrences is both unsatisfying and hazardous. To believe that we cannot forecast them and hence must prepare and model for our financial future without them is to invite problems. Nonetheless, this is often what corporations, people, and even governments do.
Diversification and Harry Markowitz
Gigerenzer discusses Harry Markowitz’s Nobel Prize-winning work on diversification, particularly Markowitz’s invention of current portfolio theory (MPT).Gigerenzer contends that it would need data spanning over 500 years for it to operate. He humorously observes that one bank, which marketed its methods based on Markowitz-style diversification, sent out its letters 500 years too early. Markowitz genuinely depended on intuition after receiving the Nobel Prize.
The typical asset allocation models did not perform well during the 2008 and 2009 financial crises. Diversification is still required, but intuitive ways may be just as useful as sophisticated models, which simply cannot include black swan occurrences in any meaningful way.
Taleb advises against entrusting a nuclear power plant or your money to someone with a financial motivation. Maintain a balance between financial complexity and simplicity. A diversified fund is one approach to do this. Certainly, the quality varies significantly, but if you locate a decent one, you can genuinely leave the diversification to one source.
Avoid looking back. Be realistic about what you truly understood back then, and don’t expect it to happen again, at least not in the same manner. Take uncertainty seriously; it is a fact of life. No computer algorithm can predict it. Don’t put too much stock in projections. Markets might definitely be too high or too low, but relying on trustworthy, precise projections is a pipe dream.
The Bottom Line
Predicting financial markets is possible, but it requires as much chance and intuition as expertise and precise models. Too many black swan occurrences may occur, rendering even the most complicated models useless. This is not to say that modeling and forecasting cannot or should not be done. However, we must also depend on intuition, common sense, and simplicity.
Furthermore, investment portfolios must be designed to be as crisis- and black-swan-proof as feasible. Diversification, continual monitoring, rebalancing, and other old friends are less likely to fail us than models that are inherently incapable of taking everything into consideration. Indeed, the most trustworthy forecast is that the future will continue to be a mystery, at least in part.
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