The Reading Room

The Black Swan: The Impact of the Highly Improbable

Nassim Nicholas Taleb

Published: 2010, Penguin

The term black swan, as the book begins by explaining, refers to highly improbable events that catch even the shrewdest minds by surprise and have the potential to wreak havoc on the status quo. The name stems from the long held belief that all swans were white. However, in 1697 Dutch explorers sighted black swans for the first time in Western Australia, completely nullifying this understanding.

From here, the term morphed into describing the occurrence of the unforeseen. It is also worth noting that the inverse, a highly expected event not happening, falls into the same category. The sighting of the black swans illustrated a severe limitation learning from observations or experiences, and the fragility of our knowledge.

For an event to be characterised as a black swan, it needs to have three characteristics:

  1. It should be an outlier
  2. It should have a massive impact
  3. Humans should be able to rationalise the occurrence of the event after it has happened, in spite of its status as an outlier (by which I mean that, ex-post, it will become explainable and predictable)

Black swans are unpredictable not because they are random, but primarily because our outlook, knowledge or field of experience is too narrow to grasp the possibility that the improbable can also happen. As such, they cannot be measured. This immeasurability and the human tendency of discounting their very possibility contributes to their ability to have a large impact.

The book extends the concept of black swan to the financial world with the field of finance regularly attempting to capture outlier events, and failing with equal regularity. Financial professionals use models to capture uncertainty, but, as is evident from history, most portfolio and risk management models fail to capture black swans. The bell curve is a popular method to understand the probability of risk but they only serve to measure the normal or average occurrence and tend to ignore the large deviations; they are largely ineffective in capturing unexpected and potentially disastrous events.

This is not just true for finance professionals, we see it as well in organised sports where following rules is imperative. Since athletes are trained to make certain moves they become weaker when faced with unexpected events. For example, boxers adhere to certain rules which makes them more vulnerable in a street fight because they are not trained to expect illegal moves. In real life, you don’t know the odds, you need to discover them.

The book moves on to focus on the premise that “The past is never a reliable predictor of the future”. One of the biggest errors that humans make while trying to predict the future is a proclivity to use historic data to explain what might occur in the future. We look backwards to weave a narrative for the future that makes sense to us. We expect the future to unfold accordingly and are caught off guard when it does not. In other words, we try to make sense where there is none. The best way to avoid the traps of narrative fallacy is to eschew storytelling in favour of experimentation, history in favour of experience and theory in favour of knowledge.

When faced with the task of assessing real world risk, we treat it as a game, assuming certain ground rules and probabilities that we can determine at the onset. This gives us the false sense that we know what is going to happen next and that the decision we are making is the right one. While it is hard for us to assess risk accurately in the real world, oversimplifying it can only make it worse.

For example, if you observe a coin flip where the dealer tells you the coin is fair (i.e. lands on heads or tails 50:50), but it comes up heads 99 times in a row, would you really believe the odds are still 50:50 on the next toss? Statistically speaking, the odds haven’t changed, but any reasonable person would assume that the coin is rigged and bet heads. So what should we do? How do we deal with black swans if we can never accurately predict them? The key is to focus on “anti-knowledge”, or simply on the things that we do not know. Instead of naively trying to predict black swans, we should try to adjust to their existence. And when we adjust to them, we can position ourselves not only to limit the downsides, but also to take advantage of positive black swans, or “serendipitous black swans”. In general, positive black swans take longer to show their effect, unlike their negative counterparts where this happens very quickly – indeed, it is much easier and faster to destroy than it is to build.

Taleb concludes that the best way to manage black swans is to snub them. They are inevitable and uncontrollable but we can control how we react to them. For example, missing a train is only painful if you run after it, if you allow yourself to care. If you simply shrugged it off and told yourself that you can just board the next one, the impact will be minimal.

In Taleb’s words, “Quitting a high-paying position, if it is your decision, will seem a better payoff than the utility of the money involved (this may seem crazy, but I’ve tried it and it works). This is the first step toward the stoic’s throwing a four-letter word at fate. You have far more control over your life if you decide on your criterion by yourself.”

The Black Swan tells us that extreme events will occur and will continue to impact us in myriad ways, but since these events cannot be predicted, it is important to adjust to them. As an investor, you can ensure that your portfolio can withstand a black swan event by following the principles of portfolio diversification and asset allocation. By spreading your investments across multiple asset classes and uncorrelated investment products, you are ensuring that the impact of an extreme event is limited.

Dhaval Somaiya
January 2021

The information contained above and in other entries in the Ocean Dial Book Review Series is intended for general information and entertainment purposes only, and should not be relied upon in making, or refraining from making, any investment decisions. No information provided herein should or can be taken to constitute any form of advice or recommendation as to the merits of any investment decision. You should take independent advice from a suitably qualified investment adviser before making any investment decisions.

Ethical Dilemmas of a Civil Servant

Anil Swarup

Published: 2020, Unique Publishers

What are the challenges that hinders an officer’s pursuit of ethical conduct? Does it pay to remain ethical while the unethical, seemingly, rules the roost? These questions plague the thought process of every civil servant. This book is contextualises a framework that will help civil servants make a learned decision. It is an aid to help them find their moral compass.

Read more

The Moonstone

Wilkie Collins

Published: 1868, reprinted by Penguin Classics (1998)

The Moonstone is one of the first true works of detective fiction, in which Wilkie Collins established the groundwork for the genre itself. The intricate plot and modern technique of multiple narrators made Wilkie Collins’s 1868 work a huge success in the Victorian sensation genre.

Read more

Only the paranoid survive

Andrew S. Grove

Published: 1997, HarperCollins Business

How to exploit crisis points that challenge every company and career. The President and CEO of Intel, the world’s largest chipmaker, reveals how to identify and exploit the key moments of change in any industry that generates either drastic failure or incredible success.

Read more

Range: How Generalists Triumph in a Specialized World

David Epstein

Published: 2019, Riverhead Books (Penguin Random House)

This book explores how to cultivate that broad range of knowledge, how to get diverse and inter-disciplinary experience in a world which is getting hyper-specialised.

Read more

Atomic Habits

James Clear

Published: 2018, Penguin Random House

Atomic habits tries to explain how even tiny changes (as small as 1%) if done consistently can have a huge impact on eventual outcomes. Tiny habits performed everyday amplify your success. They help you grow into a person you wish to become.

Read more

The Order of Time

Carlo Rovelli

Published: 2018 (English edition), Penguin Books

Over the last 150 years, our understanding about time and space has undergone a radical transformation.In ‘The Order of Time’, the Italian physicist Carlo Rovelli, explores the illusion of time, calling it the “greatest mystery”.

Read more

Artificial Intelligence: A Guide for Thinking Humans

Melanie Mitchell

Published: 2019, Pelican

Questions such as will AI take over the world, cause mass unemployment, make humans obsolete or create a Marxist utopia feel like they are in abundance today.

Read more

Investing – The last liberal art

Robert G. Hagstrom

Published: 2013, Columbia University Press

Liberal arts is a study of history, literature, writing, philosophy, sociology, psychology, creative arts and more. The objective of this book is to encourage investors to increase their knowledge of other disciplines in order to facilitate better decision…

Read more

Merger Masters –Tales of Arbitrage

Kate Welling and Mario Gabelli

Published: 2018, Columbia Business School Publishing

Rather than being a technical tome, this book articulates the rewards and challenges of risk arbitrage through stories. Divided into two parts, the first runs through seventeen leading practitioners with a chapter allocated to each.

Read more

Sea of Poppies

Amitav Ghosh

Published: 2008, Viking Press India

Sea of Poppies, a complex and magnificent tale, is an historical drama novel and part of the Ibis’ trilogy, novels written by Ghosh covering the opium trade between India and China during the first half of the 19th century.

Read more

The Made-in-India Manager

R. Gopalakrishnan, Ranjan Banerjee

Published: 2018, Hachette India

With some of the world’s leading companies boasting Indian management, Gopalakrishnan and Banerjee’s book explores what it is that makes Indian born and bred managers so successful on a global scale.

Read more

Disclaimer

IT IS IMPORTANT THAT YOU READ THE CONTENTS OF THIS NOTICE CAREFULLY BEFORE ACCESSING THIS WEBSITE. THIS NOTICE GOVERNS YOUR ACCESS TO AND USE OF THE WEBSITE. BY ACCESSING THE WEBSITE YOU AGREE TO ACCEPT THE TERMS OF THIS NOTICE AND THE FOLLOWING TERMS OF USE. IF YOU DO NOT AGREE TO ABIDE BY THESE, YOU MUST STOP USING THIS WEBSITE IMMEDIATELY.

This website is provided by Ocean Dial Asset Management Limited, whose Registered Office is at 13/14 Buckingham Street, London WC2N 6DF and Registered Number 05583807. Ocean Dial Asset Management Limited is authorised and regulated by the Financial Conduct Authority (“the FCA”), with registered number 447424.

NOT FOR U.S. PERSONS
The information contained herein does not constitute a distribution, an offer to sell or the solicitation of an offer to buy any securities in any jurisdiction in which such distribution or offer is not authorised. In particular, the information herein is not for distribution and does not constitute an offer to sell or the solicitation of any offer to buy any securities in the United States of America or to or for the benefit of any U.S. Person as such term is defined under the United States Securities Act of 1933, as amended.

No investments or services mentioned on this website are directed at U.S. Persons who are not Professional Clients or Eligible Counterparties as defined by the UK Financial Conduct Authority (FCA) Handbook or Qualified Purchasers as defined under the Investment Company Act of 1940. The information contained herein does not constitute a distribution, an offer to sell or the solicitation of an offer to buy any securities in any jurisdiction in which such distribution or offer is not authorised.

THIS WEBSITE IS ONLY MADE AVAILABLE TO PROFESSIONAL CLIENTS AND ELIGIBLE INVESTORS AND COUNTERPARTIES.

ODAM does not manage money for retail clients. Eligible investors only may access ODAM’s expertise through the funds or investment companies for which it acts as investment manager.

This website is not directed at you if Ocean Dial Asset Management Limited (“ODAM”) is prohibited by any law of any jurisdiction from making the information on this site available to you, and is not intended for any use which would be contrary to local law or regulation. This website and its contents are not intended to sell services or products over the Internet, rather for Internet viewer convenience and information purposes.

Information displayed in this website contains material that may be interpreted by the relevant authorities in the country from where you are viewing the website as investment advertising or an offer to purchase securities. Accordingly the information on this website is only intended to be viewed by the persons who fall outside the scope of any law that seeks to regulate investment advertising in the country of your residence or in the country in which the website is being viewed. Users of this website are therefore assumed to have the knowledge and experience in business and financial matters to enable them to evaluate the merits of, and risks of, investing in the investment funds referred to in this website. Persons of any other description should not enter this website nor rely on any of the information contained therein. If you are uncertain about your position under the laws of the country in which the website is being viewed then you should seek clarification by obtaining legal advice from a lawyer practising in the country of your residence or in the country in which the website is being viewed before completing this question.

Risk warnings

Investments may fall as well as rise and investors may lose a substantial portion or even all of their investment. Past performance is not necessarily a guide to future performance.

Investments denominated in foreign currencies can result in the risk of loss from currency movements as well as movements in the value, price or income derived from the investments themselves.

Investment in emerging markets involves risks which may not be typically associated with investing in more developed markets. Investment in small- and mid-cap stocks may also involve a higher degree of risk as these markets tend to be more volatile than their larger capitalisation counterparts.

Disclaimer

To the extent permitted by relevant law and regulation, ODAM expressly disclaims any and all liability which may derive from this website or any other information provided by ODAM in connection with this website, and any errors therein or omissions therefrom. The description of the investment management services and processes provided by ODAM in this website is written in general terms. The services and investment funds referred to in this website should not be regarded as an offer nor solicitation for such services or investment funds in any jurisdiction where such offer or solicitation is unlawful. The terms and conditions applicable to individual investors investing in investment funds managed by ODAM are set out in each relevant fund’s offering document. This website contains information designed only to provide background material for determining whether or not to consider investment. This website should be read in conjunction with the relevant offering document for each fund. All potential investors must carefully read the offering document which will contain significant additional information needed to evaluate investment in the fund and important disclosures regarding risks, fees and expenses. The offering document is the sole document upon which potential investors should rely. Recipients in any doubt about the content of this website should seek advice from an independent professional adviser.

This website is based upon information that is considered to be reliable but ODAM does not represent or warrant that it is accurate or complete, nor should it be relied upon as such. Views and opinions expressed within this website including comments on sectors or individual stocks or companies are those of ODAM and its Mumbai based affiliated company Ocean Dial Asset Management India Private Limited (a company incorporated in the Republic of India) as at the date of publication. Subsequent events may cause these views to change. The investment policies and procedures described are guidelines and not rules. Occasional deviation from the parameters given may result.

Use of links
The ODAM website may contain links to websites operated by other parties. ODAM does not control the content or accuracy of information on such websites and does not in any way confirm or endorse the material placed on such sites. The links are provided for your reference only.

Copyright
The copyright and all other rights in all of the material on this website are owned by the company listed on the web page or the material is included with the permission of the rights owner. You may review and copy material on this website for your own private or domestic use only. All other copying or use is prohibited.

Governing law
You agree that in the event of any dispute of any nature that may arise between you and ODAM, these terms and conditions shall be governed by and construed exclusively in accordance with the law of England and Wales and you agree to be subject to the exclusive jurisdiction of the courts of England and Wales.

Privacy policy
Any personal information that you supply ODAM via the website and other means will be held in accordance with the General Data Protection Regulation – please see our privacy notice for more details . If you would like to be removed from our database at any point, please email your request to enquiries@oceandial.com

Use of cookies
For the purposes of gathering data to measure traffic and patterns of usage on our website, we need to use your IP-address. In addition, for example, we use cookies to ascertain as to whether you have agreed to our disclaimer.
A cookie is a small file held on your PC. If you do not want to accept cookies, you will need to alter the setting on your internet browser. We will not use your IP-address or any cookie to identify you personally.