The barking swan

I recently attended an investor conference where, as is typical these days, people gathered to reaffirm how clueless we are about the future of our economy.

Just to bang the point home, the keynote speaker was Nassim Taleb, author of “The Black Swan”; a “treatise” on how our failure to take into account eventualities that are possible only remotely, yet are highly consequential, can really hurt us.

These highly remote but highly consequential events are the black swans. The metaphor comes from the story that, before the discovery of Australia, everyone thought that all swans are white (what fools!). Moreover, according to Taleb, black swan events, in retrospect, appear very plausible–but only in retrospect.

Taleb seemed to draw tremendous pleasure from being invited to wine, dine and, for a nice sum, give a speech to those very “imbeciles” who got it wrong because “they didn’t want to hear” (him).

Before I go any further, let me say for the sake of full disclosure that I have not read the book, though I understand (from Taleb’s hour of self-promotional spiel) that it makes a number of good points about how reality is, as opposed to how we (fool ourselves to) think it is.

But this is not about the book, reviews of which there are aplenty. It’s about the suggestion that the present financial crisis is a validation of Taleb’s vilifying statements about economists, statisticians, finance professionals and their entire canon. Oh yes, and the French!

Well it’s not. First, because the current crisis is not a black swan. Alas, the world’s economic history has offered a slew of (very consequential) credit and banking crises (see here for a free sample from the IMF). So not only aren’t credit crises highly remote; they can be a no-brainer, particularly if they involve extending huge loans to people with no income, no jobs and no assets.

Monday morning quarterbacking, Taleb would counter. Not really. There were certainly a few “doomsayers” (stress “a few”) in the academic and investor community, who did warn about the impending downturn and the consequences of loose credit standards. Some took contrarian positions and made money! Some had even attended the economics or finance programs that Taleb dismisses.

Getting the diagnosis right is critical for coming up with the right proposals. And Taleb’s proposals are either impractical or secondary (barring the plain obvious).

First, because aside from our often inadequate models, there were a few other blatant failures that contributed to the current crisis: The collapse of oversight by regulators and investors themselves, driven by a mix of uncritical laissez-faire ideology, the avid search for yield as global liquidity ballooned and, in some cases, fraud. Unless we fix these, even the most perfect models will not shield us from a black swan.

But then again, Taleb does not ask us to seek perfection. Instead he proposes we acknowledge our ignorance and protect ourselves.

“Beware of the Black swan!”, he warns. But what does this mean in practice? For example, I work at one of the top floors of a high-rise building in Manhattan—with a (less than remote) probability that my floor might get hit by a flying suicide bomber dressed as Superman.

Pretty consequential, if you care. But what should I do? Change jobs? Move to Peoria? Maybe Taleb can get me a parachute, a golden one please, which would get me to the Bahamas and solve my life worries once and for all! Alternatively, I can keep on living as I do, aware that I’m running the risk of becoming a case number in Homeland Security’s terrorist statistics.

Taleb’s recommendations on asset allocation are as impractical—barring generalities (like diversification or more equity than debt) that are indisputable for being self-evident. But what about the specifics?

Sure, you can put 80% of your money to US Treasury bills, to make your portfolio more robust. But if the world were to follow his advice, we would be effectively delegating the bulk of investment decisions to the government! Is this the kind of world we should aspire for?

Taleb also recommends that we buy insurance against good black swans—that is, investments with a tremendous (though still highly remote) upside but limited downside. For example, you could buy insurance against the (unlikely?) disappearance of Botox due to the discovery of the nectar of eternal youth. And make tons of money if it happens. Perhaps, only that, during extreme events, insurers can go bust too (a three-letter acronym comes to mind).

Ultimately, no matter how imperfect our models are, the problem lies in our failure to use our brain. Only “using our brain” does not mean buying Treasuries. It means identifying investments that are productive and viable, improve our quality of life and create jobs. It also means knowing what our models are designed to capture and what they are not–in which case overriding our models is the appropriate response.

This crisis has offered plenty of food for thought and plenty of lessons to munch on. But Taleb’s proposals are impractical, inefficient and, arguably, boring. After all, for all its scares and potholes, New York is more fun than Peoria. And in the (highly remote) chance that I have any Peorian readers, you have a free invitation to come over and check for yourselves!


Originally published at the Models & Agents blog and reproduced here with the author’s permission.

30 Responses to "The barking swan"

  1. CLS   December 15, 2008 at 10:53 am

    I believe Taleb himself says the current financial crisis is not a black swan. Btw, I have followed a strategy similar to what Taleb recommends, albeit without having known of Taleb or his recommendations, by putting most of my money in safe assets (money markets for me, which used to be safe) and the rest in risky assets (net long option positions) and it has paid off. Maybe if I had been managing (playing with) other peoples’ money, an apparently renewable resource, I would have been more inclined to follow traditional methods. But knowing that an adverse move could wipe out years’ of savings and investing, I wasn’t willing to gamble.

  2. Econophile   December 15, 2008 at 1:05 pm

    Taleb calls this crisis a white swan because he, and others, saw it coming. As you are no doubt aware, the fund with which he is connected, Universa, had returns of up to 100+% in some of their accounts. I also think you miss his point. I highly recommend you read his books before you criticize them. And, please, don’t perpetuate the fairy tale that the crisis was caused by laissez-faire capitalism.

  3. BrianSJ   December 15, 2008 at 1:55 pm

    One of the things that is likely to come back into fashion is knowing what you are talking about. As said by Econophile, read the books before criticizing the arguments and mis-interpreting them.

  4. Anonymous   December 15, 2008 at 5:25 pm

    Same Again. Same Again. Listen guys, the only solution to this problem is to let the Elephants die. What Taleb says is this ” DO NOT PLAY WITH PUBLIC MONEY; PUT YOUR OWN BL***DY AR*E IN LINE”.Banks are public institutions and are no better than Government run ones. Atleast in goverernment we can change the government. Why else you guys have rushed to Government with begging bowl? You are scratching against wrong tree. Lots of people have read Taleb and understand and support it.We know you guys understand it but are too much into the sh*t to acknoledge it.

  5. Anonymous   December 16, 2008 at 8:43 am

    You fault Taleb’s strategy by pointing out about how insurers can go bust during extreme events. Taleb himself has said that Universa never trades CDS contracts because buying a CDS is like buying insurance on the Titanic from someone who is on the Titanic. Please do your diligence before writing at length about any topics going forward–it’s for your own good.

  6. Anonymous   December 17, 2008 at 7:50 pm

    Author needs to read and understand the book ‘Black Swan’. This not a book for portfolio or asset management. Its a reality check and understand and uncertainities and lack of risk management models to handle these uncertainities.