* The historian Niall Ferguson showed that, despite all the standard accounts of the buildup to the Great War, which describe “mounting tensions” and “escalating crises,” the conflict came as a surprise. Only retrospectively was it seen as unavoidable by backward-looking historians. Ferguson used a clever empirical argument to make his point: he looked at the prices of imperial bonds, which normally include investors’ anticipation of government’s financing needs and decline in expectation of conflicts since wars cause severe deficits. But bond prices did not reflect the anticipation of war. Note that this study illustrates, in addition, how working with prices can provide a good understanding of history.
* We will see in Chapter 10 some clever quantitative tests done to prove such herding; they show that, in many subject matters, the distance between opinions is remarkably narrower than the distance between the average of opinions and truth.
* I then realized that the great strength of the free-market system is the fact that company executives don’t need to know what’s going on.
* I specialized in complicated financial instruments called “derivatives,” those that required advanced mathematics—but for which the errors for using the wrong mathematics were the greatest. The subject was new and attractive enough for me to get a doctorate in it.
Note that I was not able to build a career just by betting on Black Swans—there were not enough tradable opportunities. I could, on the other hand, avoid being exposed to them by protecting my portfolio against large losses. So, in order to eliminate the dependence on randomness, I focused on technical inefficiencies between complicated instruments, and on exploiting these opportunities without exposure to the rare event, before they disappeared as my competitors became technologically advanced. Later on in my career I discovered the easier (and less randomness laden) business of protecting, insurance-style, large portfolios against the Black Swan.
Chapter Two
YEVGENIA’S BLACK SWAN
Pink glasses and success—How Yevgenia stops marrying philosophers—I told you so
Five years ago, Yevgenia Nikolayevna Krasnova was an obscure and unpublished novelist, with an unusual background. She was a neuroscientist with an interest in philosophy (her first three husbands had been philosophers), and she got it into her stubborn Franco-Russian head to express her research and ideas in literary form. She dressed up her theories as stories, and mixed them with all manner of autobiographical commentary. She avoided the journalistic prevarications of contemporary narrative nonfiction (“On a clear April morning, John Smith left his house. …”). Foreign dialogue was always written in the original language, with translations appended like movie subtitles. She refused to dub into bad English conversations that took place in bad Italian.*
No publisher would have given her the time of day, except that there was, at the time, some interest in those rare scientists who could manage to express themselves in semi-understandable sentences. A few publishers agreed to speak with her; they hoped that she would grow up and write a “popular science book on consciousness.” She received enough attention to get the courtesy of rejection letters and occasional insulting comments instead of the far more insulting and demeaning silence.
Publishers were confused by her manuscript. She could not even answer their first question: “Is this fiction or nonfiction?” Nor could she respond to the “Who is this book written for?” on the publishers’ book proposal forms. She was told, “You need to understand who your audience is” and “amateurs write for themselves, professionals write for others.” She was also told to conform to a precise genre because “bookstores do not like to be confused and need to know where to place a book on the shelves.” One editor protectively added, “This, my dear friend, will only sell ten copies, including those bought by your ex-husbands and family members.”
She had attended a famous writing workshop five years earlier and came out nauseated. “Writing well” seemed to mean obeying arbitrary rules that had grown into gospel, with the confirmatory reinforcement of what we call “experience.” The writers she met were learning to retrofit what was deemed successful: they all tried to imitate stories that had appeared in past issues of The New Yorker—not realizing that most of what is new, by definition, cannot be modeled on past issues of The New Yorker. Even the idea of a “short story” was a me-too concept to Yevgenia. The workshop instructor, gentle but firm in his delivery, told her that her case was utterly hopeless.
Yegvenia ended up posting the entire manuscript of her main book, A Story of Recursion, on the Web. There it found a small audience, which included the shrewd owner of a small unknown publishing house, who wore pink-rimmed glasses and spoke primitive Russian (convinced that he was fluent). He offered to publish her, and agreed to her condition to keep her text completely unedited. He offered her a fraction of the standard royalty rate in return for her editorial stricture—he had so little to lose. She accepted since she had no choice.
It took five years for Yevgenia to graduate from the “egomaniac without anything to justify it, stubborn and difficult to deal with” category to “persevering, resolute, painstaking, and fiercely independent.” For her book slowly caught fire, becoming one of the great and strange successes in literary history, selling millions of copies and drawing so-called critical acclaim. The start-up house has since become a big corporation, with a (polite) receptionist to greet visitors as they enter the main office. Her book has been translated into forty languages (even French). You see her picture everywhere. She is said to be a pioneer of something called the Consilient School. Publishers now have a theory that “truck drivers who read books do not read books written for truck drivers” and hold that “readers despise writers who pander to them.” A scientific paper, it is now understood, can hide trivialities or irrelevance with equations and jargon; consilient prose, by exposing an idea in raw form, allows it to be judged by the public.
Today, Yevgenia has stopped marrying philosophers (they argue too much), and she hides from the press. In classrooms, literary scholars discuss the many clues indicating the inevitability of the new style. The distinction between fiction and nonfiction is considered too archaic to withstand the challenges of modern society. It was so evident that we needed to remedy the fragmentation between art and science. After the fact, her talent was so obvious.
Many of the editors she later met blamed her for not coming to them, convinced that they would have immediately seen the merit in her work. In a few years, a literary scholar will write the essay “From Kundera to Krasnova,” showing how the seeds of her work can be found in Kundera—a precursor who mixed essay and metacommentary (Yevgenia never read Kundera, but did see the movie version of one of his books—there was no commentary in the movie). A prominent scholar will show how the influence of Gregory Bateson, who injected autobiographical scenes into his scholarly research papers, is visible on every page (Yevgenia has never heard of Bateson).
Yevgenia’s book is a Black Swan.
* Her third husband was an Italian philosopher.
Chapter Three
THE SPECULATOR AND THE PROSTITUTE
On the critical difference between speculators and prostitutes—Fairness, unfairness, and Black Swans—Theory of knowledge and professional incomes—How Extremistan is not the best place to visit, except, perhaps, if you are a winner
Yevgenia’s rise from the second basement to superstar is possible in only one environment, which I call Extremistan.* I will soon introduce the central distinction between the Black Swan–generating province of Extremistan and the tame, quiet, and uneventful province of Mediocristan.
THE BEST (WORST) ADVICE
When I play back in my mind all the “advice” people have given me, I see that only a couple of ideas have stuck with me for life. The rest has been mere words, and I am glad that I did not heed most of it. Most consisted of recommendations such as “be measured and reasonable in your statements,” contradicting the Black Swan idea, since empirical
reality is not “measured,” and its own version of “reasonableness” does not correspond to the conventional middlebrow definition. To be genuinely empirical is to reflect reality as faithfully as possible; to be honorable implies not fearing the appearance and consequences of being outlandish. The next time someone pesters you with unneeded advice, gently remind him of the fate of the monk whom Ivan the Terrible put to death for delivering uninvited (and moralizing) advice. It works as a short-term cure.
The most important piece of advice was, in retrospect, bad, but it was also, paradoxically, the most consequential, as it pushed me deeper into the dynamics of the Black Swan. It came when I was twenty-two, one February afternoon, in the corridor of a building at 3400 Walnut Street in Philadelphia, where I lived. A second-year Wharton student told me to get a profession that is “scalable,” that is, one in which you are not paid by the hour and thus subject to the limitations of the amount of your labor. It was a very simple way to discriminate among professions and, from that, to generalize a separation between types of uncertainty—and it led me to the major philosophical problem, the problem of induction, which is the technical name for the Black Swan. It allowed me to turn the Black Swan from a logical impasse into an easy-to-implement solution, and, as we will see in the next chapters, to ground it in the texture of empirical reality.
How did career advice lead to such ideas about the nature of uncertainty? Some professions, such as dentists, consultants, or massage professionals, cannot be scaled: there is a cap on the number of patients or clients you can see in a given period of time. If you are a prostitute, you work by the hour and are (generally) paid by the hour. Furthermore, your presence is (I assume) necessary for the service you provide. If you open a fancy restaurant, you will at best steadily fill up the room (unless you franchise it). In these professions, no matter how highly paid, your income is subject to gravity. Your revenue depends on your continuous efforts more than on the quality of your decisions. Moreover, this kind of work is largely predictable: it will vary, but not to the point of making the income of a single day more significant than that of the rest of your life. In other words, it will not be Black Swan driven. Yevgenia Nikolayevna would not have been able to cross the chasm between underdog and supreme hero overnight had she been a tax accountant or a hernia specialist (but she would not have been an underdog either).
Other professions allow you to add zeroes to your output (and your income), if you do well, at little or no extra effort. Now being lazy, considering laziness as an asset, and eager to free up the maximum amount of time in my day to meditate and read, I immediately (but mistakenly) drew a conclusion. I separated the “idea” person, who sells an intellectual product in the form of a transaction or a piece of work, from the “labor” person, who sells you his work.
If you are an idea person, you do not have to work hard, only think intensely. You do the same work whether you produce a hundred units or a thousand. In quant trading, the same amount of work is involved in buying a hundred shares as in buying a hundred thousand, or even a million. It is the same phone call, the same computation, the same legal document, the same expenditure of brain cells, the same effort in verifying that the transaction is right. Furthermore, you can work from your bathtub or from a bar in Rome. You can use leverage as a replacement for work! Well, okay, I was a little wrong about trading: one cannot work from a bathtub, but, when done right, the job allows considerable free time.
The same property applies to recording artists or movie actors: you let the sound engineers and projectionists do the work; there is no need to show up at every performance in order to perform. Similarly, a writer expends the same effort to attract one single reader as she would to capture several hundred million. J. K. Rowling, the author of the Harry Potter books, does not have to write each book again every time someone wants to read it. But this is not so for a baker: he needs to bake every single piece of bread in order to satisfy each additional customer.
So the distinction between writer and baker, speculator and doctor, fraudster and prostitute, is a helpful way to look at the world of activities. It separates those professions in which one can add zeroes of income with no greater labor from those in which one needs to add labor and time (both of which are in limited supply)—in other words, those subjected to gravity.
BEWARE THE SCALABLE
But why was the advice from my fellow student bad?
If the advice was helpful, and it was, in creating a classification for ranking uncertainty and knowledge, it was a mistake as far as choices of profession went. It might have paid off for me, but only because I was lucky and happened to be “in the right place at the right time,” as the saying goes. If I myself had to give advice, I would recommend someone pick a profession that is not scalable! A scalable profession is good only if you are successful; they are more competitive, produce monstrous inequalities, and are far more random, with huge disparities between efforts and rewards—a few can take a large share of the pie, leaving others out entirely at no fault of their own.
One category of profession is driven by the mediocre, the average, and the middle-of-the-road. In it, the mediocre is collectively consequential. The other has either giants or dwarves—more precisely, a very small number of giants and a huge number of dwarves.
Let us see what is behind the formation of unexpected giants—the Black Swan formation.
The Advent of Scalability
Consider the fate of Giaccomo, an opera singer at the end of the nineteenth century, before sound recording was invented. Say he performs in a small and remote town in central Italy. He is shielded from those big egos at La Scala in Milan and other major opera houses. He feels safe as his vocal cords will always be in demand somewhere in the district. There is no way for him to export his singing, and there is no way for the big guns to export theirs and threaten his local franchise. It is not yet possible for him to store his work, so his presence is needed at every performance, just as a barber is (still) needed today for every haircut. So the total pie is unevenly split, but only mildly so, much like your calorie consumption. It is cut in a few pieces and everyone has a share; the big guns have larger audiences and get more invitations than the small guy, but this is not too worrisome. Inequalities exist, but let us call them mild. There is no scalability yet, no way to double the largest in-person audience without having to sing twice.
Now consider the effect of the first music recording, an invention that introduced a great deal of injustice. Our ability to reproduce and repeat performances allows me to listen on my laptop to hours of background music of the pianist Vladimir Horowitz (now extremely dead) performing Rachmaninoff’s Preludes, instead of to the local Russian émigré musician (still living), who is now reduced to giving piano lessons to generally untalented children for close to minimum wage. Horowitz, though dead, is putting the poor man out of business. I would rather listen to Vladimir Horowitz or Arthur Rubinstein for $10.99 a CD than pay $9.99 for one by some unknown (but very talented) graduate of the Juilliard School or the Prague Conservatory. If you ask me why I select Horowitz, I will answer that it is because of the order, rhythm, or passion, when in fact there are probably a legion of people I have never heard about, and will never hear about—those who did not make it to the stage, but who might play just as well.
Some people naïvely believe that the process of unfairness started with the gramophone, according to the logic that I just presented. I disagree. I am convinced that the process started much, much earlier, with our DNA, which stores information about our selves and allows us to repeat our performance without our being there by spreading our genes down the generations. Evolution is scalable: the DNA that wins (whether by luck or survival advantage) will reproduce itself, like a bestselling book or a successful record, and become pervasive. Other DNA will vanish. Just consider the difference between us humans (excluding financial economists and businessmen) and other living beings on our planet.
Furthermore, I believe tha
t the big transition in social life came not with the gramophone, but when someone had the great but unjust idea to invent the alphabet, thus allowing us to store information and reproduce it. It accelerated further when another inventor had the even more dangerous and iniquitous notion of starting a printing press, thus promoting texts across boundaries and triggering what ultimately grew into a winner-take-all ecology. Now, what was so unjust about the spread of books? The alphabet allowed stories and ideas to be replicated with high fidelity and without limit, without any additional expenditure of energy on the author’s part for the subsequent performances. He didn’t even have to be alive for them—death is often a good career move for an author. This implies that those who, for some reason, start getting some attention can quickly reach more minds than others and displace the competitors from the bookshelves. In the days of bards and troubadours, everyone had an audience. A storyteller, like a baker or a coppersmith, had a market, and the assurance that none from far away could dislodge him from his territory. Today, a few take almost everything; the rest, next to nothing.
By the same mechanism, the advent of the cinema displaced neighborhood actors, putting the small guys out of business. But there is a difference. In pursuits that have a technical component, like being a pianist or a brain surgeon, talent is easy to ascertain, with subjective opinion playing a relatively small part. The inequity comes when someone perceived as being marginally better gets the whole pie.
In the arts—say the cinema—things are far more vicious. What we call “talent” generally comes from success, rather than its opposite. A great deal of empiricism has been done on the subject, most notably by Art De Vany, an insightful and original thinker who singlemindedly studied wild uncertainty in the movies. He showed that, sadly, much of what we ascribe to skills is an after-the-fact attribution. The movie makes the actor, he claims—and a large dose of nonlinear luck makes the movie.
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