Monday, June 16, 2008

The Black Swan

Really interesting piece on Nassim Nicholas Taleb the author of the Black Swan. Very eccentric individual.

The important thing is this: the lost passport and the spilt tea were black swans, bad birds that are always lurking, just out of sight, to catch you unawares and wreck your plans. Sometimes, however, they are good birds. The recorders cost $20 less than the marked price owing to a labelling screw-up at Circuit City. Stuff happens. The world is random, intrinsically unknowable. “You will never,” he says, “be able to control randomness.”


Last May, Taleb published The Black Swan: The Impact of the Highly Improbable. It said, among many other things, that most economists, and almost all bankers, are subhuman and very, very dangerous........The world banking system still teeters on the edge of meltdown. Taleb had been vindicated. “It was my greatest vindication. But to me that wasn’t a black swan; it was a white swan. I knew it would happen and I said so. It was a black swan to Ben Bernanke [the chairman of the Federal Reserve]. I wouldn’t use him to drive my car. These guys are dangerous. They’re not qualified in their own field.”


For the non-mathematician, probability is an indecipherably complex field. But Taleb makes it easy by proving all the mathematics wrong. Let me introduce you to Brooklyn-born Fat Tony and academically inclined Dr John, two of Taleb’s creations. You toss a coin 40 times and it comes up heads every time. What is the chance of it coming up heads the 41st time? Dr John gives the answer drummed into the heads of every statistic student: 50/50. Fat Tony shakes his head and says the chances are no more than 1%. “You are either full of crap,” he says, “or a pure sucker to buy that 50% business. The coin gotta be loaded.”

The chances of a coin coming up heads 41 times are so small as to be effectively impossible in this universe. It is far, far more likely that somebody is cheating. Fat Tony wins. Dr John is the sucker. And the one thing that drives Taleb more than anything else is the determination not to be a sucker. Dr John is the economist or banker who thinks he can manage risk through mathematics. Fat Tony relies only on what happens in the real world.


He had realised that when markets rise they tend to rise by small amounts, but when they fall – usually hit by a black swan – they fall a long way.

I completely agree which goes completely against conventional wisdom. I would much rather sell a naked call than a naked put for this reason. I think the risk is much lower though finance would beat into your head the opposite.

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