The Black Swan
by Nassim Nicholas Taleb
The Black Swan by Nassim Nicholas Taleb is sort of a follow-up to his earlier Fooled By the Randomness, which dealt with why people are poorly suited decision-making in the face of uncertainty.
The Black Swan deals with the “impact of the highly improbable” and argues that these events, dubbed Black Swans, are far more common then we think, in part because of the perverse influence of modern statistics which assumes all kinds of things are normally distributed except for the minor detail that they aren’t. No one sees them coming, but in retrospect people manage to explain them.
The book is full of wide-ranging applications of his thesis, great asides and mildly misanthropic comments about businesspeople, anyone in finance, economists, particularly Nobel Prize winners, German philosophers, forecasters of any kind, opera fans and the French.
The core of the book is the distinction between Mediocristan and Extremistan. Mediocristan is the world of the normal distribution, where outliers are extremely rare. Many physical characteristics have a normal distribution, such as height or weight. In Mediocristan, it is not at all likely that an additional observation will impact the sum of all observations in any significant way. Extremistan is very different and is the domain of the power law distribution. An outlier observation can dwarf the sum of all previous observations, such as Bill Gates entering the room when you’re observing wealth. Big swathes of the real world, particularly social dynamics and informational goods, are in Extremistan, are not normally distributed and we treat them as Mediocristan at our peril.
The bulk of the book examines why we are so blind to Black Swans and gets into a fair amount of behavioral psychology like the earlier book. Not surprisingly, we tend to look for things that reaffirm our beliefs as opposed to contradict them; we’re good at constructing stories to explain things after the fact; we tend to ignore the silent evidence “of cemeteries” and focus disproportionately on the winners (think survivorship bias); assume the real world abides by clear and understandable rules; and we generally overestimate what we know and underestimate what we don’t.
The book is kind of a bummer in that he doesn’t have much of a prescription for how to survive and thrive in Extremistan. Basically, he attributes success to “undirected trial and error” and encourages you to maximize your exposure to as many positive Black Swans as possible. Better to be lucky than good.
He applies his thinking to a variety of different realms with very intriguing results. As a former options trader, he basically denounces Modern Portfolio Theory as complete bunk, a castle built on shifting Gaussian sands. He asserts that a mere ten days over the last fifty years account for HALF of the market’s performance. Needless to say, that means some very fat tails. He also revels in the various explanations of the blow-up of Long-Term Capital Management and needles the Nobel Prize winning economists who were involved at length. Taleb implied in an interview that his own portfolio is roughly 80% T-bills and 20% exposure to positive Black Swans with unlimited upside which sounds like venture capital of some form.
He arrives at a similar conclusion as Andy Kessler on globalization and division of labor. Don’t sweat the US’s trade deficit. That is just revenue: just look at the balance of profits (where the US runs a surplus). He believes the US has focused on scaleable businesses where your revenue is not limited by your number of labor hours, but rather those that involve creativity and are often winner-take-all in the global economy. We export jobs for the non-scaleable elements to others who are happy to be paid by the hour: “There is more money in designing a shoe than actually making it; Nike, Dell and Boeing can get paid for just thinking, organizing and leveraging their know-how and ideas while subcontracted factories in developing countries do the grunt work and engineers in cultured and mathematical states do the noncreative technical grind”.
He also looks at innovation. I’ve always believed that any successful technology has a strong element of serendipity in its adoption (standards body denizens hate it when you point this out and this would be a wonderful area to add up the “silent evidence” of failures) and he makes the same point, even using the word serendipity.
In short, it is a great and thought-provoking read.