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Black Swan Theory – Being prepared for the unpredictable

December 12, 2012

Black Swan Theory – Being prepared for the unpredictable.

Just because an event or thing has not been witnessed or discovered till date doesn’t prove its non-existence. Such a thing or event might exist and once spotted it’s called a Black Swan.

Why Black Swan?… Black Swan was a term used to define a statement of impossibility because till 1697, the time black swan was spotted for the first time, it was believed that swans are only white in color. Since the discovery of  black swan, the term is used as a metaphor to refer to an event of surprise.

This post summarizes the important concepts and points of Black Swan Theory given by Prof Nassim Nicholas Taleb.

 What is Black Swan event?

According Nassin Taleb, a black swan event is a low probability, high impact event that is almost impossible to predict or forecast.

 Attributes of Black Swan event –

1. Black Swan event is a surprise to the observer. It happens outside the realms of normal expectations.

2.Black Swan event has a major impact (positive or negative)

3.After its first appearance, it gets explained(relevant data was available but not counted, miscalculated data etc)  , therefore making it look like it could have predicted.

Although, professionals have established approaches to predict the uncertainties and calculate risk to a great extent but some events, owing to their dynamics, stand largely outside the realm of the predictable. No historical data or empirical record is sufficient to forecast a black swan event because it has never occurred before. To attempt to any possibility of predicting black swan event, one needs to think “out of the box”, not relying upon any hypothetical or mathematical theories of probabilities or risk calculations because a Black Swan event is the one beyond normal expectations and  predictions. In the age of record players, who would have thought that music can be played in compact devices like IPods. Invention of CDs, DVDs, IPods etc was is a black swan event, of course with positive impact.

Some Black Swan events which became cause of a major change in our world are-

-Computer.

-World trade Tower attack 9/11

-Internet

So , if a black swan event is almost unpredictable, what is this theory all about?

 The theory of Black Swan event deals with three aspects –

  1. Attempt to predict Black Swan event. Thinking beyond possibilities, trying to anticipate extreme events.
  2. Building robustness against negative black swan events. This can be done by holding safer portfolio’s and  organizational absorption*
  3. Extracting benefit from a positive black swan event , utilizing it for growth, knowledge and progress.  This is called Anti-Fragility.**

Why we fail to forecast Black Swan event? – Normal Distribution vs Heavy tail Distribution

Prof Taleb emphasizes on the fact that traditional measures like Value-at-Risk or Gaussian function cannot predict all uncertainties. In the markets, the probability of outsized event is much higher than that predicted by normal distribution (Gaussian distribution). A normal distribution is not strictly valid because in normal distribution, as  sample size increases, the observed average will present itself with less and less dispersion  and  thus, uncertainty vanishes. On the contrary, heavy tailed distributions are very useful statistical concepts when it comes to modeling of rare events with high impact. Heavy tailed distributions exhibit extremely large skewness

normal vs heavy chain distribution

 

 

 

 

 

 

 

Some ways for predicting a Black Swan are summarized as

  1. Not to rely totally on past experiences.
  2. Not to depend on standard deviations for risk calculations.
  3. Recognize the fact that mathematical equivalent can be psychologically different.
  4. Understanding that Black Swan events are always unique and therefore not subject to testing in repeatable experiments.
  5. Develop ability to take into account the properties of the future.

In summary, Black Swan theory holds significance in social, economic and personal context. It prepares us for the future which is prone to uncertainties – inevitably breaking as black swan, promotes the idea of building robustness and psychologically, turning the event to our benefit.

 

*Organizational Absorption is company’s capacity to accommodate unfavorable and disadvantageous situations and market trends. Contingency saving funds, emergency credit lines are some of the defensive techniques used by organizations.

 **Prof Taleb has coined a term Anti-Fragility which means not only withstanding a Black Swan event but also improving because of it.

 

Recommended read – The Black Swan: The Impact of the Highly Improbable by Prof Nassim Nicholas Taleb

 

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