The Sunday Times UK has an excellent, lengthy interview with Nassim Nicholas Taleb, author of The Black Swan: The Impact of the Highly Improbable. Published last May, it has had huge impact, the idea that unpredicted events can change everything and that most aren’t prepared for them. Indeed, almost by definition, you can’t be prepared for. Google was a Black Swan, so was Black Monday in Oct 1987 when the stock market crashed.
Taleb was a trader then and had realized that the market goes up fairly slowly but when it goes down, it can happen fast and furiously. So, he’d been buying out of the money puts (don’t try this at home, kids) and when the crash happened, made enough to retire. Such a crash, by traditional financial models, wasn’t supposed to happen. But it did.
He does not think the current credit crisis is a Black Swan and predicted it would happen. Much of the blame for it is due to banker types who think they can manage risk effectively with theoretical models.
“But to me [the credit crisis] wasn’t a black swan; it was a white swan. I knew it would happen and I said so. It was a black swan to Ben Bernanke [the chairman of the Federal Reserve]. I wouldn’t use him to drive my car. These guys are dangerous. They’re not qualified in their own field.”
In his book, he describes when a hedge fund blew up. I think it was LTCM and they almost took the world financial system down with them. Their models conclusively showed that risk was never more than three standard deviations. Enter reality. What took them down was a six standard deviation event.
His Fat Tony parable illuminates his primary point.
Let me introduce you to Brooklyn-born Fat Tony and academically inclined Dr John, two of Taleb’s creations. You toss a coin 40 times and it comes up heads every time. What is the chance of it coming up heads the 41st time? Dr John gives the answer drummed into the heads of every statistic student: 50/50. Fat Tony shakes his head and says the chances are no more than 1%. “You are either full of crap,” he says, “or a pure sucker to buy that 50% business. The coin gotta be loaded.”
Dr John is the economist or banker who thinks he can manage risk through mathematics. Fat Tony relies only on what happens in the real world.
Taleb has a website at www.fooledbyrandomness.com