Black Swan Theory (Taleb)

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Black Swans do exist!

What is a Black Swan? Definition

Black swans were presumed not to exist since the days of Juvenal and Aristotle. Actually, the term was always used as a statement of impossibility.

However in 1697, Dutch explorer Willem de Vlamingh made the first European record of sighting a black swan in 1697 when he sailed into, and named, the Swan River on the western coast of New Holland, the later Australia.


Protection to Black Swans. The Decision Theory of Anti-Fragility

According to Nassim Nicolas Taleb, a Black Swan Event is a low-probability, high-impact event that is impossible to forecast or predict.

In his 2007 book The Black Swan: The Impact of the Highly Improbable he says we currently live in a world of opacity, where knowledge is overestimated and chance and uncertainty are underestimated. We don't know what we don't know!


Banks and trading firms are seen as very vulnerable to hazardous Black Swan events and are exposed to losses beyond those that are predicted by their defective financial models. The main idea in Taleb's book is not to attempt to predict Black Swan Events, but to build robustness to negative ones that occur (compare Organizational Absorption), and being able to exploit positive ones (anti-fragility), for example by making a profit out of it (compare Strategic Agility).


Taleb is developing a new decision-making theory. This theory aims to reduce the impact of threats we don't understand, instead of perpetuating the illusion of control that we can anticipate the future (as is typically done in credit and operational risk management).


To achieve this, Taleb introduces a decision-making model consisting of 4 quadrants:

  1. Mild randomness ('Mediocristan'), thin tail (regular Bell Curve) + Simple binary, yes-no payoff
  2. Wild randomness ('Extremistan'), heavy or unknown tail + Simple binary, yes-no payoff
  3. Mild randomness ('Mediocristan'), thin tail (regular Bell Curve) + Complex, expectation based payoff
  4. Wild randomness ('Extremistan'), heavy or unknown tail + Complex, expectation based payoff

 

According to Taleb, we have to worry particularly about the fourth quadrant, which is dealing with complex, expectation-based decisions in the domain of wild randomness (with heavy and/or unknown tails, having no or unknown characteristic scale). Using statistics in this quadrant is extremely dangerous (See also Plausibility Theory).

The decision theory of Anti-fragility tries to return from this fourth quadrant to the second or third quadrant.

In the other quadrants (1, 2 and 3) you can use statistics quite safely.


Identifying Black Swan Events

Taleb mentions 3 criteria to indentify a black swan:

  1. The event is a surprise (to the observer).
  2. The event has a major impact.
  3. After its first recording, the event is rationalized by hindsight, as if it could have been expected (e.g., the relevant data were available but not accounted for). 'Black Swans' are often misunderstood and even ignored by humans. This is partly caused by cognitive biases, in particular: hindsight bias, bandwagon effect and narrative fallacy, confirmation bias and silent evidence, status quo bias, illusion of control bias and ludic fallacy, and overconfidence bias.

A problem of induction is that "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single Black Swan is sufficient to refute that conclusion." (David Hume, 1711-1776, Scottish philosopher and economist).


Common Mistakes When Confronting Risk

According to Taleb (HBR October 2009) managers make 6 common errors when confronting risk:

  1. They try to anticipate extreme events.
  2. They study the past for guidance.
  3. They disregard advice about what not to do.
  4. They use standard deviations to measure risk.
  5. They fail to recognize that mathematical equivalents can be psychologically different.
  6. They believe there's no room for redundancy when it comes to efficiency.

According to Taleb (Business Week 2008, #7), banks have a tendency to sit on time bombs while convincing themselves that they are conservative and nonvolatile. Furthermore Taleb  blames the science of risk management for causing this behavior, and business schools and the financial economics establishment for having a vested interest in promoting risk management models and devaluing common sense.

 

Nassim Nicolas TalebAbout Nassim Taleb

Nassim Nicholas Taleb was born in Lebanon in 1960 and received his bachelor and master in science degrees from the University of Paris. He holds an MBA from the Wharton School at the University of Pennsylvania and a PhD in Management Science from the University of Paris. His thesis was on the mathematics of derivatives pricing.

He is a former trader for various financial firms on Wall Street and was a professor at several universities.


Obsessed by chance, randomness and uncertainty, in 2004 Taleb publishes the first print of his book Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets in which he sees an overestimation of skills and an underestimation of luck.

He criticizes risk management methods used by the finance industry and warns for upcoming financial crises. Indeed in 2008-2010 the financial (banking) crisis occurs, based on too much debt, agency problems (bonus without malus), complexity and leverage.


Usage of Black Swan Theory. Applications

  • Risk management
  • Finance
  • Decision-making
  • Strategy
  • Dealing with complexity
  • Economic system

Strengths of Black Swan Theory. Benefits

  • Increased awareness of uncertainty in decision making.
  • Insight in the veins of the causes of the 2008 crises.
  • New way to deal with risks and uncertainty.
  • An alternative for current economic system (Taleb is against big governments and large companies)

Limitations of Black Swan Theory. Disadvantages

  • Use in complex, chaotic conditions (Compare also: Cynefin Framework)
  • Taleb is a maverick and Black Swan Thinking is rather extreme.
  • Theory is not yet mainstream.
  • A decision theory based on anti-fragility is still work in progress.

Assumptions of Black Swan Theory. Conditions

  • Black Swans cannot be predicted because they are rare.
  • Overestimation of knowledge; underestimation of randomness and uncertainty.
  • Overestimation of skills; underestimation of luck in life.
Black Swan Thinking Forum
  Taleb's Mathematical Foundation: Silent Risk
Taleb has just completed the mathematical foundation supporting his other books (Antifragile, The Black Swan, The bed of Procrustus and Fooled by Randomness). He calls this: "Silent Risk".
Silent Risk is the finishing part of Taleb's Ince...
     
 
  Skin in the Game!
To ensure proper handling of risks by managers in both commercial and public organizations, it's important to make them p...
     
 
  The Role of Entrepreneurs in Antifragility at Society Level
Taleb adores entrepreneurs. They take a lot of downside risk bad for themselves (a lot of them will default), but on a macro level entrepreneurs are very good for society. Taleb compares entrepreneurs with soldiers who have in fact only downsi...
     
 
  How to be Antifragile?
Taleb says the shortest summary of the Bible is: don’t do to others what you don’t want others do to you.
A friend of Taleb believes the summary of his incerto (combination of his main works: 'The Black Swan", 'Fooled by Randomness' and his rec...
     
 
  Fat Tony and Dr. John ...
In the Black Swan and his other books, Taleb distinguish between two types of knowledge, each with it's own funny archetype:
- Rational / formal / Plato / Soviet / Harvard classroom knowledge. Taleb uses ' 
   
 
  Nassim Taleb Biography | Taleb Profile and Background of Black Swan
FAMILIY BACKGROUND: Nassim Nicolas Taleb was born in Amioun, Lebanon in 1960 as son of an old, well known family. His father was an oncologist and his grandfather vice prime minister of Lebanon.

EDUCATION: Taleb received an MBA from Whart...
     
 
  Decision-making in Uncertain Circumstances
When we're dealing with severe uncertainty, should we start to use heuristics (rules of thumb) instead of complex models?
Taleb thinks that using (simple) heuristics is, in the fourth quadrant (w...
     
 
  No Bonus without Malus. The Agency problem.
Taleb gives some principles for a system, organization, or society to be robust against black swans. In my opinion, an important one is:
Don't let someone with an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he wo...
     
 
  Imagining Black Swan Risks - an ERP Experience
During an ERP implementation I have come across some important users who imagine and articulate Black Swan scenes and make the ERP solution complex. Quite often due to legacy systems' limitations, some of the extra tasks which are normal for new syst...
     
 
  Why Black Swans are Unnoticed
Imran Khan is sweeping the political ‘show castles’ as none could have thought or dreamed of a year ago. He has described his yesterday’s rally in Lahore as a ‘tsunami’ – a tsunami it was -- and ripples are being felt from Washington to Tokyo, from M...
     
 
  Causes of Black Swan Risks
Apparently Black Swan risks are more probable in case of higher complexities of financial systems or other decision making processes. The normal curve portrays the expected situation for any given system. The attempts to try and push the whole...
     
 
  Black Swan is like Murphy's Law
Black Swan is an interesting concept. It seems in tune with Murphy's Law (Whatever can go wrong, will go wrong...).
In my opinion it is a challenge; the crazier and the more intutive one is, the more is the chance of survival and growth and sust...
     
 
  The Past as a Predictor of the Future
The main thesis of the Black Swan is true to the extent that people use the past to predict the future, not because it is true, but because it is easier.
In Kenya, there seems to be a currency plunge every 5th year and this almost always sees th...
     
 
  The Role of Experts in Causing Black Swans
Looking at events in the financial world over the past 3 years in particular that were triggered by sub-prime loans in the US, I believe that Black Swans are caused by those 'experts' creating 'instruments' and thinking out theories and publishing ab...
     
 
  How can Scenarios Help to Prepare for Black Swans?
I wonder in what way scenario-management and future scorecards can help private and public organizations, but also individuals to become "prepared" for a Black Swan event. Is there somebody who can give some advise here?...
     
 
  The Role of Statistics in Predicting Black Swans
Events having a major impact and a low probability are termed Black Swans... I am agreeing to the point that statistics has not much of a role to play in predicting them, but at the same time with the help of statistics we can know what will ...
     
 
  Black Swan Important for Top Management
Black Swan Thinking is so true... yet most top managers still rely on and use statistics. I'm hoping they take this information and put it to good use....
     
 
  Black Swan Theory and Business Valuation Practice
The Black Swan principle and key conclusions of Taleb were not brand new even in 2007 (though he presented it first in form of a theory).
For example it is said that "business valuation is an art and not a science". (Business valuation has a lot...
     
 

Black Swan Thinking Special Interest Group


Special Interest Group

 

Best Practices - Black Swan Thinking Premium
  How Fragile is your Organization?
In his brand new book 'Antifragile', Nassim Nicolas Taleb takes his method of dealing with Black Swans to a new level. No, you still can't predict Black Swans. These low-probability, high-impact events ...
     
 
  Noise to Signal Ratio in Decision-making
In Taleb's book "Fooled by Randomness", noise versus signal plays an important role.
If you are making complex decisions, exposure to too much data can cause severe side-effects.
Nowadays there's lots of data, because of the blessings of co...
     
 
  How to Prepare for Black Swan Risks?
According to Nassim Taleb, we can not prevent Black Swan risks (= rare events with a high impact) from happening now and then. But we CAN prepare for them. How?
Taleb is giving the followin...
     
 


Expert Tips - Black Swan Thinking Premium
 

How to Use Intuition in Decision Making Properly?

Matzler, Uzelac and Bauer (2014) have written a very interesting article on good Managerial decision making and the constraint...
Usage (application): Intuitive Decision Making, Adductive Reasoning, Bounded Rationality, Cognitive Biases, Managerial Decision-making
 
 
 

Narrative-based Scenario Planning

Traditional scenario-planning generally provides a bigger picture in which trends and shocks are revealed. Such scenarios are effective in detecting t...
Usage (application): Scenario Planning, Strategic Agility, Anti-Fragility
 
 
 

How to Use Counterintuition to Fight 5 Frequent Decision Making Errors

Mauboussin describes five mistakes in decision making that are often made and result in making the wrong decisions. These five mistakes are:
1...
Usage (application): Strategic Decision Making, Dealing with Complexity, Dealing with Uncertainty, Strategy
 
 
 

3 Steps in Solving Problems with Data Credibility

The problem of data credibility
Data credibility problems have been existed for many years. Due to this credibility problem, knowledge wor...
Usage (application): Improving Data Reliablility, IT, Business Intelligence
 
 


Resources - Black Swan Thinking Premium

How to Apply the COSO Enterprise Risk Management Integrated Framework

This presentation elaborates on the concept of Enterprise Risk Management and the COSO ERM Framework, sections:
1. What today’s organizations are...
Usage (application): Enterprise Risk Management, COSO ERM Framework
 

Critical Thinking in Decision Making

Presentation about critical thinking for decision making, including the following sections:
1. Failure of Imagination
2. Untested Assumption...
Usage (application): Critical Thinking, Testing Assumptions, Avoiding Fallacies, Avoiding Biases, Dealing with Emotions
 

Responding to Large Scale, Large Impact and Rare Events

Presentation about Black Swans and recognizing, assessing and reacting to them.
Dealing with Large Scale, Large Impact, Rare Events (LSLIRE’s). Usage (application): Strategic Decision Making, Black Swan
 

Interview with Taleb and Mandelbrot on the Financial Crisis

Various fragments of an interview with Nassim Taleb and Benoit Madelbrot on the financial crisis....
Usage (application): Black Swan Theory, Training, Workshops
 
 

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Compare with: Chaos Theory  |  Catastrophe Theory  |  Game Theory  |  Scenario Planning  |  Dialectical Inquiry  |  Analogical Strategic Reasoning  |  Plausibility Theory

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