Having been captive on a cruise ship this past week, I was fortunate to find the book “The Black Swan – The Impact of the Highly Improbable” in the ship’s library. The author (Nassim Nicholas Taleb) rails against applying the normal or "Gaussian" distribution to the real world.
Instead, Taleb focuses on the “Black Swan”, a sudden, unexpected, game-changing event that was not predicted in advance yet regardless has a huge impact on future events. The origin of the term is that bird scientists considered all swans to be white until they found the first Black Swan. Examples of Black Swans are 9/11, the collapse of LTCM and the success of Google.
Social scientists and portfolio managers have for years based their planning assumptions on the curve to the left which assumes that "2-Sigma" or 2 Standard Deviation events occur less than 5% of the time. Instead these seeming rare events occur much more often and instead blindside their unexpecting victims with devestating affects. Graph on the left is from Wikipedia at http://en.wikipedia.org/wiki/Standard_deviation
Consider a turkey living on a farm. After having been fed for 1000+ days, the Turkey has every reason to beleive he will continue to be fed regularly by his human keepers. Then one he misses a meal then Chop! Happy Thanksgiving! Madoff anyone?
Rather than prove case statistically, Taleb points out these deficits in human perception:
- We focus on what we know and neglect what we do not know. You've read the books in your library, but how big is your anti-library (books you have not read)?
- Once we have an opinion, we tend to avoid data that doesn't match our conclusions and instead focus on data that meets our expectations. Social scientents call this "Confirmation Bias".
- We ignore the vast audience of "silent evidence" such as failed companies, Hedge Funds, money managers etc. We model our assumptions instead on the statistics of the survivors. This bias tends to ignore the investments that failed completely and thus underestimates your chances of a failed investment.
Much of this book went over my head, but I did get his much. Taleb's message is "Dont be a sucker." But don't sweat the small stuff either. Life as we know it is so incredibly improbable.
As magician Shawn Farqhuar said on the ship (and I'm sure he didn't coin it). "Yesterday is history, tomorrow is a mystery and today is a gift. That's why the call it the present."