All That Glitters / The 'Black Swan' Song of Nassim Taleb

Taleb's economics book, 'The Black Swan: The Impact of the Highly Improbable', published in 2007, has become increasingly popular in light of recent events in Japan.

Nassim N. Taleb, author of "The Black Swan: The Impact of the Highly Improbable" (Random House, 2007 ), and one of the few who predicted much of the recent economic meltdown, refused to grant an interview last week. He'd received more than 600 requests for interviews following recent events in Japan, he wrote on his website, and turned them all down. Except for one.

Why is he back in fashion with such a vengeance? Taleb, formerly a successful options dealer, became famous by virtue of his book on probabilities in economics. He coined the phrase the "black swan": a rare event of very low probability, that will affect the entire world. He chose black swan because in 16th-century London, people used the term to describe something that didn't exist, until - in 1697 - Dutch explorers found such birds in western Australia.

Black Swan - Yaron Kaminsky
Yaron Kaminsky

Taleb's black swan is an event that meets three criteria, the first being extreme scarcity. Second, it must have great impact, and third, people will typically find explanations about why the phenomenon actually could have been foreseen.

There are plenty of examples: President John F. Kennedy's murder in 1963, the terror attacks on the Twin Towers in 2001, or Lehmann Brothers' collapse in 2008. You can add the earthquake, tsunami and nuclear crisis in Japan to the list: Nobody thought all these things would happen, but they have an enormous impact and yet could have been foreseen.

Taleb won't talk directly about the Japanese situation, but his website does: The Japanese Nuclear Commission estimated that the probability that there will be a fatality in the vicinity of the nuclear plants due to an accident would be one in a million years, Taleb writes. And eight years later, it happened.

He goes on to complain that he has spent the last 20 years trying to explain "mostly to finance imbeciles, but also to anyone who would listen to me" why small probabilities should not be a topic of discussion: Science can't deal with them, he explained, and it is wrong for governments to make people think they can rely on such insignificant probabilities - "except for natural systems that have been standing for 3 billion years." One certainly can't rely on such probabilities (such as one in a million ) when dealing with manmade systems that have been around for just a few years or decades.

Nassim Taleb - Bloomberg

Taleb's mathematics are complicated, but his conclusions are not:

1. Small probabilities are incomputable, and the smaller they are, the harder they are to calculate.

2. Present models lead small probabilities to be underestimated.

3. These models cause the likelihood of horrible events with small probability to be even more underestimated.

4. Because of globalization and the fact that all markets and countries are interlinked, the economic cost of natural catastrophe rises in a nonlinear fashion.

5. If a person calculates the probability of a rare event and his life depends on that rare event not happening - for instance, a nuclear meltdown - he's already underestimating the probability of that event.

There are a lot of black swans out there, not only the Japanese event. The uprising in the Arab nations starting in Tunisia and Egypt is a black swan that has lifted oil prices, arousing fear that living standards will drop in all sorts of nations, and it halted the rise by share prices.

Black swans don't have to be negative events - some can surprise on the upside: for instance, the advent of a new technology, such as cheap energy. The invention of the Internet is precisely that sort of "white" black swan, if you will: It created whole new industries and bettered the lives of millions. The events playing out in the Arab nations could also be a "white" black swan, if they lead to the rise of fast-growing democracies. For Israel, the discovery of large amounts of oil on top of the gas already found could be a swan, though it remains to be seen if it's white or black.

Two years ago I spoke with Taleb, who is a Christian from Beirut. He said he had lived through war and knew that a person cannot predict what the morrow will bring. He therefore tends to ascribe enormous importance to buying insurance, an investment that generates no returns, costs money, hurts one's investment returns and is therefore, loathed by traditional investment advisers. But a person needs to be prepared for rare events with enormous importance, he feels: He needs to take out insurance against disaster of all types and to invest most of his money in conservative assets. A certain amount, just a little, can be channeled into ultimate risk ventures such as hedge funds.

Taleb has no compunction about attacking the economic-financial-government establishment that rules most countries. For years he's been attacking bank managers, investment managers and the leaders of economic policy in the United States. In the last year he hasn't been invited to important events, and sat aside during the World Economic Forum at Davos. People often don't like him; some call him a charlatan. But events like tsunamis and the malfunction in the Japanese reactors show that Taleb can be right on the money.

There are a lot of black swans out there and they always take us by surprise anew.