The Black Swan

by Nassim Nicholas Taleb

  PHRONETIC RULES: WHAT IS WISE TO DO (OR NOT DO) IN REAL LIFE TO MITIGATE THE FOURTH QUADRANT IF YOU CAN’T BARBELL?

  The most obvious way to exit the Fourth Quadrant is by “truncating,” cutting certain exposures by purchasing insurance, when available, putting oneself in the “barbell” situation described in Chapter 13. But if you are not able to barbell, and cannot avoid the exposure, as with, say, climate notions, exposure to epidemics, and similar items from the previous table, then we can subscribe to the following rules of “wisdom” to increase robustness.

  1. Have respect for time and nondemonstrative knowledge.

  Recall my respect for Mother Earth—simply because of its age. It takes much, much longer for a series of data in the Fourth Quadrant to reveal its properties. I had been railing that compensation for bank executives, who are squarely in the Fourth Quadrant, is done on a short-term window, say yearly, for things that blow up every five, ten, or fifteen years, causing a mismatch between observation window and window of a sufficient length to reveal the properties. Bankers get rich in spite of long-term negative returns.

  Things that have worked for a long time are preferable—they are more likely to have reached their ergodic states. At the worst, we don’t know how long they’ll last.*

  Remember that the burden of proof lies on someone disturbing a complex system, not on the person protecting the status quo.

  2. Avoid optimization; learn to love redundancy.

  I’ve discussed redundancy and optimization in Section I. A few more things to say.

  Redundancy (in terms of having savings and cash under the mattress) is the opposite of debt. Psychologists tell us that getting rich does not bring happiness—if you spend your savings. But if you hide it under the mattress, you are less vulnerable to a Black Swan.

  Also, for example, one can buy insurance, or construct it, to robustify a portfolio.

  Overspecialization also is not a great idea. Consider what can happen to you if your job disappears completely. Someone who is a Wall Street analyst (of the forecasting kind) moonlighting as a belly dancer will do a lot better in a financial crisis than someone who is just an analyst.

  3. Avoid prediction of small-probability payoffs—though not necessarily of ordinary ones.

  Obviously, payoffs from remote events are more difficult to predict.

  4. Beware the “atypicality” of remote events.

  There are suckers’ methods called “scenario analysis” and “stress testing”—usually based on the past (or on some “make sense” theory). Yet (I showed earlier how) past shortfalls do not predict subsequent shortfalls, so we do not know what exactly to stress-test for. Likewise, “prediction markets” do not function here, since bets do not protect an open-ended exposure. They might work for a binary election, but not in the Fourth Quadrant.

  5. Beware moral hazard with bonus payments.

  It’s optimal to make a series of bonuses by betting on hidden risks in the Fourth Quadrant, then blow up and write a thank-you letter. This is called the moral hazard argument. Bankers are always rich because of this bonus mismatch. In fact, society ends up paying for it. The same applies to company executives.

  6. Avoid some risk metrics.

  Conventional metrics, based on Mediocristan, adjusted for large deviations, don’t work. This is where suckers fall in the trap—one far more extensive than just assuming something other than the Gaussian bell curve. Words like “standard deviation” are not stable and do not measure anything in the Fourth Quadrant. Neither do “linear regression” (the errors are in the Fourth Quadrant), “Sharpe ratio,” Markowitz optimal portfolio, ANOVA shmanova, Least square, and literally anything mechanistically pulled out of a statistics textbook. My problem has been that people can accept the role of rare events, agree with me, and still use these metrics, which leads me to wonder if this is a psychological disorder.

  7. Positive or negative Black Swan?

  Clearly the Fourth Quadrant can present positive or negative exposures to the Black Swan; if the exposure is negative, the true mean is more likely to be underestimated by measurement of past realizations, and the total potential is likewise poorly gauged.

  Life expectancy of humans is not as long as we suspect (under globalization) because the data are missing something central: the big epidemic (which far outweighs the gains from cures). The same, as we saw, with the return on risky investments.

  On the other hand, research ventures show a less rosy past history. A biotech company (usually) faces positive uncertainty, while a bank faces almost exclusively negative shocks.

  Model errors benefit those exposed to positive Black Swans. In my new research, I call that being “concave” or “convex” to model error.

  8. Do not confuse absence of volatility with absence of risk.

  Conventional metrics using volatility as an indicator of stability fool us, because the evolution into Extremistan is marked by a lowering of volatility—and a greater risk of big jumps. This has fooled a chairman of the Federal Reserve called Ben Bernanke—as well as the entire banking system. It will fool again.

  9. Beware presentations of risk numbers.

  I presented earlier the results showing how risk perception is subjected to framing issues that are acute in the Fourth Quadrant. They are much more benign elsewhere.

  * Most of the smear campaign I mentioned earlier revolves around misrepresentation of the insurance-style properties and performance of the hedging strategies for the barbell and “portfolio robustification” associated with Black Swan ideas, a misrepresentation perhaps made credible by the fact that when one observes returns on a short-term basis, one sees nothing relevant except shallow frequent variations (mainly losses). People just forget to cumulate properly and remember frequency rather than total. The real returns, according to the press, were around 60 percent in 2000 and more than 100 percent in 2008, with relatively shallow losses and profits otherwise, so it would be child’s play to infer that returns would be in the triple digits over the past decade (all you need is one good jump). The Standard and Poor’s 500 was down 23 percent over the same ten-year period.

  VIII

  THE TEN PRINCIPLES FOR A BLACK-SWAN-ROBUST SOCIETY*

  I wrote the following “ten principles” mostly for economic life to cope with the Fourth Quadrant, in the aftermath of the crisis.

  1. What is fragile should break early, while it’s still small.

  Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks become the biggest.

  2. No socialization of losses and privatization of gains.

  Whatever may need to be bailed out should be nationalized; whatever does not need a bailout should be free, small, and risk-bearing. We got ourselves into the worst of capitalism and socialism. In France, in the 1980s, the socialists took over the banks. In the United States in the 2000s, the banks took over the government. This is surreal.

  3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

  The economics establishment (universities, regulators, central bankers, government officials, various organizations staffed with economists) lost its legitimacy with the failure of the system in 2008. It is irresponsible and foolish to put our trust in their ability to get us out of this mess. It is also irresponsible to listen to advice from the “risk experts” and business school academia still promoting their measurements, which failed us (such as Value-at-Risk). Find the smart people whose hands are clean.

  4. Don’t let someone making an “incentive” bonus manage a nuclear plant—or your financial risks.

  Odds are he would cut every corner on safety to show “profits” from these savings while claiming to be “conservative.” Bonuses don’t accommodate the hidden risks of blowups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

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sp; 5. Compensate complexity with simplicity.

  Complexity from globalization and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage. It’s the leverage of efficiency. Adding debt to that system produces wild and dangerous gyrations and provides no room for error. Complex systems survive thanks to slack and redundancy, not debt and optimization. Capitalism cannot avoid fads and bubbles. Equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

  6. Do not give children dynamite sticks, even if they come with a warning label.

  Complex financial products need to be banned because nobody understands them, and few are rational enough to know it. We need to protect citizens from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

  7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence.”

  In a Ponzi scheme (the most famous being the one perpetrated by Bernard Madoff), a person borrows or takes funds from a new investor to repay an existing investor trying to exit the investment.

  Cascading rumors are a product of complex systems. Governments cannot stop the rumors. Simply, we need to be in a position to shrug off rumors, be robust to them.

  8. Do not give an addict more drugs if he has withdrawal pains.

  Using leverage to cure the problems of too much leverage is not homeopathy, it’s denial. The debt crisis is not a temporary problem, it’s a structural one. We need rehab.

  9. Citizens should not depend on financial assets as a repository of value and should not rely on fallible “expert” advice for their retirement.

  Economic life should be definancialized. We should learn not to use markets as warehouses of value: they do not harbor the certainties that normal citizens can require, in spite of “expert” opinions. Investments should be for entertainment. Citizens should experience anxiety from their own businesses (which they control), not from their investments (which they do not control).

  10. Make an omelet with the broken eggs.

  Finally, the crisis of 2008 was not a problem to fix with makeshift repairs, any more than a boat with a rotten hull can be fixed with ad hoc patches. We need to rebuild the new hull with new (stronger) material; we will have to remake the system before it does so itself. Let us move voluntarily into a robust economy by helping what needs to be broken break on its own, converting debt into equity, marginalizing the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here (by claiming restitution of the funds paid to, say, Robert Rubin or banksters whose wealth has been subsidized by taxpaying schoolteachers), and teaching people to navigate a world with fewer certainties.

  Then we will see an economic life closer to our biological environment: smaller firms, a richer ecology, no speculative leverage—a world in which entrepreneurs, not bankers, take the risks, and in which companies are born and die every day without making the news.

  After this foray into business economics, let us now move to something less vulgar.

  * This passage was published as an editorial in 2009 in the Financial Times. Some editor—who no doubt had not read The Black Swan—changed my “Black-Swan-robust” into “Black-Swan-proof.” There is no such thing as Black Swan proof, but robust is good enough.

  IX

  AMOR FATI: HOW TO BECOME INDESTRUCTIBLE

  And now, reader, time to part again.

  I am in Amioun, the village of my ancestors. Sixteen out of sixteen great-great-grandparents, eight out of eight great-grandparents, and four out of four grandparents are buried in the area, almost all within a four-mile radius. Not counting the great-uncles, cousins, and other relatives. They are all resting in cemeteries in the middle of groves of olive trees in the Koura valley at the base of Mount Lebanon, which rises so dramatically that you can see the snow above you only twenty miles away.

  Today, at dusk, I went to St. Sergius, locally called Mar Sarkis, from the Aramaic, the cemetery of my side of the family, to say hello to my father and my uncle Dédé, who so much disliked my sloppy dressing during my rioting days. I am sure Dédé is still offended with me; the last time he saw me in Paris he calmly dropped that I was dressed like an Australian: so the real reason for my visit to the cemetery was more self-serving. I wanted to prepare myself for where I will go next.

  This is my plan B. I kept looking at the position of my own grave. A Black Swan cannot so easily destroy a man who has an idea of his final destination.

  I felt robust.

  * * *

  I am carrying Seneca on all my travels, in the original, as I relearned Latin—reading him in English, that language desecrated by economists and the bureaucrats of the Federal Reserve Bank of the United States, did not feel right. Not on this occasion. It would be equivalent to reading Yeats in Swahili.

  Seneca was the great teacher and practitioner of Stoicism, who transformed Greek-Phoenician Stoicism from metaphysical and theoretical discourse into a practical and moral program of living, a way to reach the summum bonum, an untranslatable expression depicting a life of supreme moral qualities, as perceived by the Romans. But, even apart from this unreachable aim, he has practical advice, perhaps the only advice I can see transfer from words to practice. Seneca is the one who (with some help from Cicero) taught Montaigne that to philosophize is to learn how to die. Seneca is the one who taught Nietzsche the amor fati, “love fate,” which prompted Nietzsche to just shrug and ignore adversity, mistreatment by his critics, and his disease, to the point of being bored by them.

  For Seneca, Stoicism is about dealing with loss, and finding ways to overcome our loss aversion—how to become less dependent on what you have. Recall the “prospect theory” of Danny Kahneman and his colleagues: if I gave you a nice house and a Lamborghini, put a million dollars in your bank account, and provided you with a social network, then, a few months later, took everything away, you would be much worse off than if nothing had happened in the first place.

  Seneca’s credibility as a moral philosopher (to me) came from the fact that, unlike other philosophers, he did not denigrate the value of wealth, ownership, and property because he was poor. Seneca was said to be one of the wealthiest men of his day. He just made himself ready to lose everything every day. Every day. Although his detractors claim that in real life he was not the Stoic sage he claimed to be, mainly on account of his habit of seducing married women (with non-Stoic husbands), he came quite close to it. A powerful man, he just had many detractors—and, if he fell short of his Stoic ideal, he came much closer to it than his contemporaries. And, just as it is harder to have good qualities when one is rich than when one is poor, it is harder to be a Stoic when one is wealthy, powerful, and respected than when one is destitute, miserable, and lonely.

  Nihil Perditi

  In Seneca’s Epistle IX, Stilbo’s country was captured by Demetrius, called the Sacker of Cities. Stilbo’s children and his wife were killed. Stilbo was asked what his losses were. Nihil perditi, I have lost nothing, he answered. Omnia mea mecum sunt! My goods are all with me. The man had reached the Stoic self-sufficiency, the robustness to adverse events, called apatheia in Stoic jargon. In other words, nothing that might be taken from him did he consider to be a good.

  Which includes one’s own life. Seneca’s readiness to lose everything extended to his own life. Suspected of partaking in a conspiracy, he was asked by the emperor Nero to commit suicide. The record says that he executed his own suicide in an exemplary way, unperturbed, as if he had prepared for it every day.

  Seneca ended his essays (written in the epistolary form) with vale, often mistranslated as “farewell.” It has the same root as “value” and “valor” and means both “be strong (i.e., robust)” and “be worthy.” Vale.

  NOTES

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p; BEHIND THE CURTAIN: ADDITIONAL NOTES, TECHNICAL COMMENTS, REFERENCES, AND READING RECOMMENDATIONS

  I separate topics thematically; so general references will mostly be found in the chapter in which they first occur. I prefer to use a logical sequence here rather than stick to chapter division.

  PROLOGUE and CHAPTER 1

  Bell curve: When I write bell curve I mean the Gaussian bell curve, a.k.a. normal distribution. All curves look like bells, so this is a nickname. Also, when I write the Gaussian basin I mean all distributions that are similar and for which the improbable is inconsequential and of low impact (more technically, nonscalable—all moments are finite). Note that the visual presentation of the bell curve in histogram form masks the contribution of the remote event, as such an event will be a point to the far right or far left of the center.

  Diamonds: See Eco (2002).

  Platonicity: I’m simply referring to incurring the risk of using a wrong form—not that forms don’t exist. I am not against essentialisms; I am often skeptical of our reverse engineering and identification of the right form. It is an inverse problem!

  Empiricist: If I call myself an empiricist, or an empirical philosopher, it is because I am just suspicious of confirmatory generalizations and hasty theorizing. Do not confuse this with the British empiricist tradition. Also, many statisticians, as we will see with the Makridakis competition, call themselves “empirical” researchers, but are in fact just the opposite—they fit theories to the past.