- A Black Swan is an event that is epochal and unexpected. A Black Swan has the following attributes: They’re 1) rare and without the realm of common expectations, 2) has extreme impact, 3) rationalized in hindsigt as if one could have foreseen it.
- The creation/perception of meaning happens in on of two systems. System 1 is based on experience. The line of thinking is effortless, automatic and quick. We take shortcuts when applying this mindset. System 2 is thoughtful. Well-founded, logical, slow and progressive are some of the words that characterize this type of meaning creation. The overarching application of System 1 is what leads to the misconception of Black Swans.
- The chapter on “The Scandal of Prediction” explains that we’re often arrogant about what we know. We often believe that we know a bit more than we actually do. It’s this “bit” that often gets us into trouble; ‘epistemic arrogance’ leds to an underestimation of uncertainty and that which is outside our comprehension, which is why we’re never prepared when Black Swans flap their wings.
- In length, the author recommends one prepares oneself on Black Swans by investing 85% in extremely conservative investments, and 15% in extremely speculative ones. This seeks to ensure that Black Swans can’t hurt your base, but only the 15% that are placed in high-risk investments.
A few months back, I saw the Danish TV show ‘The Millionaires’ Club’ where a panel of experts characterized e.g. the election of Trump and Brexit as Black Swans. This was not, however, in accordance with the definiton I heard in The Investor’s Podcast when they reviewed Nassim Taleb’s enlightening book. Hence, I decided to pick up a copy of the book so I could dive into the concept.
Black Swans’ atonomy
Nassim explains that a Black Swan has three attributes: They’re 1) rare and without the realm of common expectations (since nothing from the past can convincingly pinpoint its probability), 2) has extreme impact, 3) rationalized in hindsigt as if one could have foreseen it, which Nassim dubs the narrative fallacy. In general, Nassim believes humans are blind to randomness. We have a need to create narratives in our efforts to give events meaning and cause.
In regards to point 1), was Brexit or the election of Trump a Black Swan? No, definitely not. It was a well-known fact that both of these events could happen. The media’s consensus pointing in another direction, indeed, but both were – and turned out to be – not an impossibility. 9/11, however, now that was a Black Swan. Unexpected, extreme impact (stock market panic, “the War on Terror” etc.) and an unheard of amount of post-rationalization (remember all those stories about how it could have been pinpointed and avoided?)
Two lines of thinking: System 1 vs. System
In our efforts to create/perceive meaning, or understand the world around us, our activities can be divided into two systems, 1 and 2. System 1 is based on experience. The line of thinking is effortless, automatic and quick. We take shortcuts when applying this mindset.This line of thinking can obviously get us into trouble. System 2 is thoughtful. Well-founded, logical, slow and progressive are some of the words that characterize this type of meaning creation. You make fewer mistakes when applying this line of thinking; as so forth you do make mistakes, you can track back to when, where, why and what caused the mistake. Nassim warns us that most of humans’ misconceptions stem from applying system 1 when we think that we’re putting system 2 at work. According to Nassim, the overarching application of System 1 is what leads to the misconception of Black Swans. It blurs our perception of probabilities for a wide range of events. If we simply use System 1, we “buy in” to the media’s and the so-called experts’ narratives. Applying System 2 and the skepticism embedded in this mindset protects os against the “easily bought” narrative. This line of thinking forces you to actually think (for yourself).
The Scandal of Prediction and the empty suits
The chapter “The Scandal of Prediction” is one of my absolute favourites. Nassim warns that we’re often arrogant about what we know. We often believe that we know a bit more than we actually do. It’s this “bit” that often gets us into trouble. The author dubs this tendency epistemic arrogance. The concept dictates that we often overrate what what we know, and underestimate uncertainty. This underestimation of uncertainty leads to a blindness towards Black Swans. Vi simply underestimate the probability of the extreme, that which is outside our realm of comprehension.
From here, Nassim bridges to the section “The Tragedy of the Empty Suit.” Nassim warns everyone from receiving advise from arrogant and incompetent persons, “the experts in the empty suits”, such as bankers, analysts, investment advisers etc. These so-called experts are basically paid to make predictions, projections and voicing opinions. It’s their job to produce said content. As they do not wish to lose their jobs by raising far-reaching ideas or opinions, they play the safe hand. They suffer from ‘tunnel-sight’, as they exclusively ‘predict’ the consensus. If they’re wrong, everyone else is wrong too, so they’re behinds are not placed in the smack-zone. This ensures an avoidance of a career-wise pickle – smart thinking, but an extremely boring read.
Preparing for the unpredictaple
What should you, as an investor, use all of these theories for? You see, Nassim suggests that you tailor your portfolio based on the self-awareness that you can’t predict the future. Hence, his investment strategy revolves around two theses: 1) the realization that you’re sensitive to prediction errors, and 2) accepting that risk-reducing measures are defect due to Black Swans’ devastating impact. Hence, he advises you to be hyper-conservative and hyper-aggressive at the same time. He advocates that one should not focus on ‘mid-risk’ investment, but rather allocate e.g. 85% of one’s portfolio in extremely conservative investments such as government bonds whereas the remaining 15% should be placed in extremely speculative bets. Following this strategy ensures that Black Swans can’t hurt your base, but only the 15% you’ve allocated to high-risk investments (with the potential of extraordinary returns). As this way of constructing one’s portfolio isn’t appealing to yours truly, I’ll let the intrigued reader discover this for him or herself (Nassim walks you through the specifics in chapter 13).
Grey Swans and The Millionaires’ Club’s empty suits
We now know that The Millionaires’ Club’s panel of experts (or empty suits, as Nassim would call them) proclamations of Black Swans were uninformed (according to Nassim’s definition, nevertheless). If we know that the stock markets can crash as they did in 1987, 2000 and 2007, the next recession is not a Black Swan. These crashes or similar impactful events can instead be characterized as Grey Swans. Nassim explains as follows: “A gray swan concerns modelable extreme events, a black swan is about unknown unknowns.” When the next recession hits, you now know that this isn’t a Black Swan, even though the media will undoubtedly try to convince that it is. You know that recessions are a recurring event: a Grey Swan.
The book is quite a rollercoaster ride of terms, concepts and theories. It’s up to the reader to put all the pieces together, but exactly this ‘challenge’ and a great amount of humor makes this book an interesting and entertaining read. A thought-provoking piece that’ll make you appreciate randomness as well as luck’s role in all aspects of life (and investing, of course).