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The Black Swan

Black SwanA professor of mine once said, “Literature has three lives. The first is when you read it, the second is when you think about it, and the third is when you re-read it.”

If that’s true, all three of Nassim Taleb’s The Black Swan’s lives have enriched my life and opened my eyes. It’s the second book in Taleb’s trilogy on randomness, risk, and probabilities, and the most well-known.

Taleb is the kind of writer you’ll either love or hate. To say he’s straightforward and direct is like referring to a hurricane as a strong wind—it’s fairly accurate, but vastly understated. I’ve grown to enjoy his combative style, but have talked to a number of people who had difficulty getting past his brashness.

The book contains so many big ideas that the difficulty in deciding where to start with this review was only eclipsed by figuring out what to exclude. I’ll break down what I feel to be the most important ideas and attempt to do them justice.

What is a black swan?

The black swan phenomenon gets its name from the old belief that all swans were white because only white swans had ever been seen before. However, once Australia was discovered, the first black swan was sighted. Finding only one black swan was enough to override the knowledge gleamed from all prior observations, likely tens of thousands of white swan sightings.

Extremistan vs. Mediocristan

Taleb states we’re living in two different worlds. The first world, Mediocristan, is where events that occur are not significant individually, only collectively, and will not affect the aggregate or total to any significant degree. The second world, Extremistan, is where the inequalities are such that one single observation (such as discovering one black swan when it was believed all swans were white) can disproportionately impact the aggregate or total in a very substantial way.

Say we gathered 1,000 randomly chosen people in a room. We carefully measure everyone’s heights and come up with an average for the group. After doing this, we invite the tallest man alive and measure his height, bringing the total to 1,001 people. As the tallest man alive is likely not even twice as tall as the average, adding his relatively extreme height will not increase the new average very much.

Head In The Clouds

A similar type of result would likely be found measuring other averages such as weight, IQ, shoe size, and life span. These are all in the realm of Mediocristan, due to the fairly unremarkable difference between average and possible extremes. Mediocristan is a world where our instincts are generally accurate, but even when they’re not, an unexpected event will not blindside you or society.

Now, let’s measure our group’s average net worth instead. Say Bill Gates strolled in. The average would increase by hundreds, possibly thousands of times over. This is what can happen in Extremistan. Rare events can be so asymmetrical they completely dominate the influence of the vast majority of other events in the realm. Extremistan events can be found in economics, stock market movements, war, earthquakes, and book and music sales, plus many more, and can be enough to undo years, decades, or even centuries of prior progress.

Nothing too exceptional (in relation to the average) ever happens in Mediocristan. In Extremistan, exceptional things rarely happen, but when they do, they are, well, extreme.

Bell Curve BS

Taleb moves on to examine how tools that work well in Mediocristan are incorrectly applied to Extremistan, sometimes at great cost. Many of us hoped for the bell curve after a difficult exam in university. Our grades would be awarded relative to our fellow students, giving us a chance at passing. This works well in Mediocristan situations like exam scores when the range of outcomes is limited—in this case 0 to 100.

However, the bell curve is very dangerous to use in Extremistan, as the mathematical properties give the false illusion of precision. In reality, the calculations are limited to what has been observed in the past, which can be hundreds or even thousands of insignificant events. You rarely have significant events in Extremistan, but they occur far more often than the bell curve predicts. Also, when they do happen, they are far more severe than the curve indicates.

For example, based on the bell curve, the stock market crash of 1987 should only have happened once every couple billion years—and it’s far from the only stock market anomaly we’ve seen over the years.

A similar naive trust in the bell curve was in part what led to the financial crash of 2008, which almost took down our entire financial system due to the sheer amount of debt borrowed. Odds are we haven’t seen the last of this behaviour.

Power Laws

You’ll have to give up any hope of precision when dealing with Extremistan situations. But, there are some tools you can use as loose guidelines, meaning they still have the tendency to oscillate from time-to-time.

Pareto Principle

Examples of these tools are power laws, also known as scaling laws, such as the 80/20 rule or Pareto principle. In the 1890s, Italian economist Vilfredo Pareto realized that 80% of the land in Italy was owned by 20% of the population. The 80/20 rule often points out that 80% of business is generated by 20% of clients. This is one of the reasons companies often provide their biggest clients with better service than other clients.

The 80/20 rule is not written in stone and different ratios are applicable in different situations. The Black Swan shows the actual distribution of people’s net worth, followed by what the bell curve would predict:

Higher than €1 million: 1 in 63
Higher than €2 million: 1 in 125
Higher than €4 million: 1 in 250
Higher than €8 million: 1 in 500
Higher than €16 million: 1 in 1,000

If wealth were based on the bell curve it would look like the following:

Higher than €1 million: 1 in 63
Higher than €2 million: 1 in 127,000
Higher than €4 million: 1 in 886,000,000,000,000,000
Higher than €8 million: 1 in 16,000,000,000,000,000,000,000,000,000,000,000
Higher than €16 million: 1 in...none of my computers are capable of handling the computation.


What is average anyway?

The term “average” both is and isn’t as simple as it seems. Taleb writes, a six-foot man shouldn’t try to cross a river that is, on average, four feet deep. When we hear “four feet deep on average”, we’re prone to picture a river that is four feet deep from bank to bank. This, however, is rarely the case. The depth may start at a few inches by the edges but gets gradually deeper until it’s actually 10 feet in the middle.

A similar mistake in, let’s say, medicine, can lead to serious issues. If you found out you had a disease in which the average life expectancy was four years, you’d likely assume you only have about three-to-five years to live. This is very different from finding out that half of the people with that disease died within months, but those that lived at least a year, could expect to live another 20 years.

Not knowing the difference between the two could lead you to spend or give away all of your money in a few years in the assumption you had little chance of living more than a few more years.

The lessons learned from melted ice

I’ve always been a big proponent of learning history, and learning from history. However, one of the things I learned from The Black Swan is the danger of learning history too well. As mentioned earlier, just because something has never happened doesn’t mean it can’t happen in the future. Before World War I, wars rarely lasted as long as four years, and even if they did, the number of casualties were somewhat constrained. On the eve of the first Great War, it would have been very unlikely for you to predict the size, scope, length, and overall horror that followed.

Another problem with learning from history is human nature’s need to explain why an event occurred—even if we don’t have access to everything that happened, we’re likely to make assumptions to fill in the gaps.

Ice Cubes

The example of melted ice will help explain. Assume you see a piece of ice on the floor. If you had the time, correct formulas and models, it’s likely you could predict how it would melt. Now pretend you walk into a room with a puddle of water. How likely is it that you could determine how the water got there? Was it from a piece of ice? Was it several pieces of ice? Perhaps it was a snowball, or a spilled glass of water.

It’s often easier to work your way forward (ice to water) than backward (water to…). But historians are forced to do the latter, which can obviously lead to a number of imperfect assumptions. This limitation affects other fields such as economics, finance, psychology, and sociology, which is why they are often imperfect sciences.

Survival bias

Survival bias is presenting a result or solution without including (whether known or not) situations in which that solution failed. Taleb rightfully feels that most books on success are useless because they don’t acknowledge the unsuccessful stories that the same advice produced, and they’re largely anecdotal.

The biggest winner at a casino usually wins because he gambled a very large amount of money and took extraordinary risks. You’d be crazy to offer that same advice to the average person, as you know it’s a strategy that’s failed more people than it’s served.

The mutual or hedge fund industry brags that the average returns of their funds are better than the index they track. Although they are correct, what they won’t mention is that the returns they are touting don’t include the funds that have been closed in previous years. Fund companies almost never close funds with good performance. It’s usually their “dogs” that get put down. By including these, you’d find well over 75% of funds underperform the index they track over a five-year period.

Luck

Man Lucky HorseshoePossibly the hardest thing for me to come to grips with in the past few years is the role luck plays in our lives. However, after reading The Black Swan and Thinking, Fast and Slow by Daniel Khanman, I’ve given into the ample research that supports their thesis. It’s generally accepted that luck (good or bad) is random, having said that, we still attribute success to a combination of skill, hard work, and determination. While this combination vastly improves your odds at success, most successful people usually had Lady Luck smile upon them at opportune times. On the flipside, others with similar skill, work ethic, and grit were never heard from again due to their bad luck.

Neither Taleb, nor I are insinuating that skill and grit don’t make a difference. They make a huge one. They increase your odds of success, and provide you more opportunities for continued success—or redemption in the case of failure. However, the genes you inherit, the family you are raised by, and the economy you live in all have an impact on your life’s path.

To use a biking analogy, luck is like the unknown road ahead; your future speed will be affected by whether it is up or downhill. Undoubtedly the better shape you are in will allow you to go much faster and farther, however, you could still lose a race to someone in worse shape than you if their road is downhill while yours is upward sloping.

The Life of a Turkey

One of the best analogies in the book is the turkey and the farmer. For 1,000 days or so the turkey thinks the farmer is on his side. The farmer feeds him, keeps him safe, and generally takes care of him. Every day is more proof that the farmer only has his best interest at heart. But then Thanksgiving rolls around and the turkey discovers everything he ever knew about the farmer was wrong.

Turkey

The biggest lesson you can get from this book is to figure out what can devastate you and either avoid it or come up with a strategy to protect yourself from it. In other words…don’t be a turkey!

The wrap

The Black Swan, along with the other main books in the series (Fooled by Randomness and Antifragile) have not only changed the way I see the world, but have convinced me I need to expand and enhance my knowledge in a number of areas.

Please note that although I’ve stayed with the major themes of The Black Swan, I have included some of my own thoughts and reflections to them. There’s also a lot I’ve left out. If any of the above has caught your attention, I highly encourage you to read this book, and read it again. You won’t regret it!