Book Review: Black Swan – The Impact Of The Highly Improbable

By The Banker | Book Reviews, How Not To Invest
4 Jan 2013
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The “Black Swan,” of Nicholas Nassim Taleb’s title, describes an event that occurs completely outside expectations, has an enormous impact on future developments, and can be explained only in hindsight as predictable. Further, Taleb argues that despite the fact that we are blind to their imminent arrival ahead of time, Black Swans drive the world more than the visible, predictable patterns around which we typically organize ourselves.

Examples of Black Swans would include the European ‘discovery’ of the American continents, Eduardo Severin’s $20,000 Facebook investment becoming $2 Billion, the rise of modern weaponry for war, the 9/11 attacks, and the Great Credit Crunch of 2008[1]

But instead of looking for Black Swans, we seem to be hardwired to search for predictable patterns to understand our world.  The typical forward-looking models we create to make sense of the world tend to assume inertia and normal distributions.  We expect the future to remain within an expected range of previously observable or predictable outcomes.  Black Swans, however, all too often overwhelm our expectation for continuity, acting like a tsunami that wipes out all our careful planning.

If you find the Black Swan view of the world compelling, how would you then organize your life and organize your investments?

Taleb’s suggested approach to both is dominated by what he calls empirical skepticism, which may be otherwise understood as doubting everything, and trying your darndest to deal with the fact that what you should be worrying most about is the thing you haven’t yet conceived of.

What you should not do, however, is trust too deeply in established patterns, impressive-seeming back-ward looking models, or anything that depends on normally-distributed bell curves.

I founded my investment fund[2] in 2004 with a compelling investment thesis, based on observable phenomenon and solid experience.  From my mortgage bond sales seat at Goldman Sachs I could see clearly that we, and thousands of our colleagues and competitors, were engaged in a headlong rush to underwrite and securitize as much consumer debt as we could possibly create on a daily, weekly, and monthly basis.  A good portion of this debt inevitably would go bad, creating huge opportunities for distressed investors who knew how to find and profit from the distress of financial institutions.

I knew something about the default and recovery rates on this type of debt, and I knew about the profitability of purchasing debt when it became distressed. In sum, I knew that we were headed for a debt reckoning, and I knew I had to set up my fund and achieve scale in time to take advantage of that reckoning.  So far, so good.  My fund grew until 2008.

The Black Swan of 2008 made it clear that instead of focusing on what I knew, I should have profitably focused on what I didn’t know.  Fund of Fund Managers can have their capital wiped out in July 2008 and demand a 100% redemption, for reasons entirely unrelated to my fund.

Let’s just say the Black Swan of 2008 swatted aside all the things I thought I knew about distressed debt investing.  It was all the things I didn’t know that killed the fund.  Taleb would argue that I focused on all the wrong risks, and I have to say, in hindsight, he was right.

Market participants could contemplate a single large broker dealer like Bear Stearns going under in March 2008.  That’s not a Black Swan.  What was harder to contemplate and therefore qualifies for Black Swan status was the simultaneous insolvency in one week in September 2008 of Lehman, AIG, Fannie Mae, and Freddie Mac, followed within weeks by the likely insolvency of money market funds and every other major financial firm.

I know I’ve already written before that I don’t like ‘How To Invest’ books, preferring instead the ‘How Not To Invest,’ book as more profitable in the long run.  Most of Black Swan may be profitably read as a ‘How Not To Invest,’ as Taleb implicitly blows up the status quo investment approaches embraced by the mainstream Financial Infotainment Industrial Complex.

However, I would be remiss if I failed to mention Taleb’s interesting investing career, which practice closely reflects his Black Swan philosophy.  He co-founded and continues to consult with a fund called Universa.  Universa purchases ‘volatility’ and ‘tail risk,’ via a long options strategy.  In plainer English his fund traditionally purchases deep out-of-the-money calls and puts, resulting in a portfolio that loses a little bit of money in most years but makes a killing when the rest of the investment world blows up due to some unforeseen, volatile, Black Swan event.

A word of caution if you’ve never read Taleb:  His personality determines his writing style more than most authors.  In his first, well-known book, Fooled By Randomness, Taleb nearly undermines his key financial and philosophical points with his abrasive style.  He slashes through ideas and people he considers lazy or wrong, never lowering the decibel level on his critique.  He improved the tone in Black Swan to the level of merely an irascible professor, making him more readable than his debut effort.

 

Please also see my review of Nassim Taleb’s Fooled by Randomness.

Please see related post: All Bankers Anonymous Book Reviews in one place.


[1] Which of course occurred after the publication of Black Swan and did more than anything to cement the value of Taleb’s skeptical empiricism approach.  Black Swan is more readable but probably less profound than his earlier book Fooled by Randomness, which I’ve reviewed here.  His latest book Antifragile, Things That Gain From Disorder is on hold at my local library.

[2] Misleadingly labeled a ‘hedge fund’

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4 Comments

  1. Richard says:

    Hey Mike, Have any book reviews or opinions on “The Number”, by Alex Berenson? Just read an old blog post by Mark Cuban on Business Insider about the realities of the stock market and was interested what your take would be on the same issue. Looking forward to your response.

  2. Roberta Maunsell says:

    Hi
    Could Nelson Mandela and the events around his life be viewed as a black swan?
    Regards
    Roberta Maunsell.

    • The Banker says:

      Hmmm. I don’t think so.
      My sense is the author Nassim Taleb believes that the “Black Swan” concept is over-applied to observed phenomena. He’s annoyed that because of his successful coinage of the term, whenever something unusual happens people say “Hey look! Black Swan.”
      I interpret his book to mean that a Black Swan even is not only rare, but that it takes almost everyone completely by surprise.
      Its transformative power – and he does think Black Swans are transformative – derives from its seeming impossibility before it happens.
      So why isn’t Nelson Mandela a Black Swan in the Taleb sense of the word?
      I think the arc of Mandela’s life, while inspirational and improbable and transformative, is not unheard of, or previously believed impossible.
      Freedom fighters against a repressive regime – who then go on to become the key moral voice of their nation – are rare but not unanticipated. The repression, in fact, may produce the freedom fighter. Any individual freedom fighter’s success is improbable, but ultimate victory over repressive regimes is not a black swan.
      A number of other people come to mind who were jailed, persecuted, or exiled by a corrupt or immoral or authoritarian regime before coming back to transform their country. On the positive side, Charles de Gualle, Martin Luther King, and Ghandhi fit the narrative. On the mixed side, Napoleon. On the negative side, Fidel Castro and Hugo Chavez.

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