review (version 1) for november issue

It is tough to make predictions, particularly about the future*

*Yogi Berra

The Black Swan by Nicholas Nassim Taleb

What happens out there in the real world? Many times I’ve peered through the iron bars of the small windows at the LSE while sitting through my class in real analysis. In the real world, some of my contemporaries could have discovered “the next Facebook” , or become the best thing to happen to an investment bank since sliced bread. Personally, I would love to sell a million copies of my as-yet unwritten future book, but I may well be serving banana caramel lattés in Starbucks ruminating about how it all went pear-shaped for me since my heady undergraduate days. It all seems a little bit unfair, and you start wondering what you could have done better or differently.

Isn’t it comforting then, that someone comes along and tells you that you shouldn’t be too hard on yourself, and that chance has a big part to play in dealing the winners and losers. It’s certainly tempting.

To Nicholas Taleb, much of the world we live in today resembles “Extremistan”. It’s a world in which events of large import and magnitude occur with small, but non-negligible probabilties. It’s a world in which payoffs are highly non-linear and “lumpy”, where a chance alignment of factors makes an author extremely rich but 999 (or more) others very poor. It is a world in which wars happen and we are confronted by our own mortality. These large events are the “Black Swans” which lend their name to the title of the book.

The author’s fixation is with uncertainty, more specifically, those black swans not unlike what former US Secretary of Defence Donald Rumsfeld once controversially dubbed “unknown unknowns”. This curiosity about rare events and how we react to uncertain events is informed by experiences in Taleb’s own life. Having observed his native Lebanon degenerate into civil war, and having contracted, and recovered, from throat cancer, he is constantly amazed how often people underestimate risk. This was especially marked in his career as a quantitative options trader, where he saw many other traders take comfort in their Gaussian models. People feed of success and the continual feeling of victory as they make profits daily in the stock market, but this is akin to picking up dimes in front of steamrollers. Taleb’s hedge fund, Empirica, adopts a different strategy of being ultraconservative (80% in T-bills) and hyperaggressive (the rest in out-of the-money options). It’s difficult to walk around most of the days of the year slowly bleeding money and making losses, yet on the days where something unexpected occurs, be it the Russian debt default, 9/11 or the recent sub-prime crisis, he makes a killing. It takes some intellectual discipline to go against our instincts and mental biases. Paradoxically, it is courageous to be prudent.

In exploring “Black Swans”, he takes us through a wide range of knowledge, drawing from his polymathic knowledge of fields such as philosophy, economics and biology. While the concepts presented are abstract and theoretical, his informal style and street sense make this read an engaging one peppered with interesting anecdotes and stories. Taleb’s book, to be fair, is not a vast collection of his original ideas. The main mantra of the book, is “don’t be too confident in what you know.” This is certainly nothing new, after all, Socrates said it all those years ago : “One thing only I know, and that is that I know nothing.” The title of the reference, is in itself an allusion to the belief that all swans were white, until the discovery of black swans in Australia demonstrated the weakness of induction as a basis of knowledge. It’s strength lies in creating an engaging synthesis of the literature to back up his theory. It introduces you to advances in mathematical finance suggested by the father of fractal geometry, Benoit Mandelbrot, and the theory of science advanced by Karl Popper. It is also a good introduction to those Nobel Prize winning psychologists, Kahnemann and Tversky, who have conducted numerous experiments investigating our heuristics and biases involved in judgement under uncertainty.

“The Black Swan” builds on his previous effort, “Fooled by Randomness”. That book contained several anecdotes of his life as a trader observing how people dealt and made decisions regarding uncertainty. Significantly, it also contained a section on how to deal with the uncertainties in life, with stoicism and good grace. This book builds on the last effort by presenting a more coherent theory with good doses of erudition.

Nassim’s style will polarize readers. He tries to write accessibly, out of memory, and has a conversational prose which is engaging yet at times loose. Less patient readers will not suffer his many digressions. He must have enjoyed writing it, however, for a book preaching epistemic humility, it does make some strong and sweeping statements. While I do agree with much of what he says about too much respect being given to those who have won a “Nobel”, some of the asides smack of having a huge axe to grind.

Yet behind the brash exterior of the book one finds heartwarming tales and consolations. That the world is random gives texture to life, and one value Taleb has as a skeptic is introspection. Things are not always going to go our way no matter how much we try, and it is the way we reflect upon, and subsequently deal with the environment around us which will preserve our dignity and give our successes and failures their proper perspective.

You shouldn’t take my word for it. After all, book reviewers are fallible. However, if you do happen to pop by the local bookstore, do take a look at it, for there are serious lessons to be learnt for everyone. For academics and practioners in finance, perhaps we should be less secure in the technical sophistication of our models and develop methods which may be less elegant, but provide a better fit for reality. For the lay person, it will provide a good dose of perspective on how to prepare ourselves for the black swans which will change our life, for better or worse.