The Black Swan: The Impact of the Highly Improbable

THE IDEA OF POSITIVE ACCIDENT

Recall the empirics, those members of the Greek school of empirical medicine. They considered that you should be open-minded in your medical diagnoses to let luck play a role. By luck, a patient might be cured, say, by eating some food that accidentally turns out to be the cure for his disease, so that the treatment can then be used on subsequent patients. The positive accident (like hypertension medicine producing side benefits that led to Viagra) was the empirics’ central method of medical discovery.

This same point can be generalized to life: maximize the serendipity around you.

Sextus Empiricus retold the story of Apelles the Painter, who, while doing a portrait of a horse, was attempting to depict the foam from the horse’s mouth. After trying very hard and making a mess, he gave up and, in irritation, took the sponge he used for cleaning his brush and threw it at the picture. Where the sponge hit, it left a perfect representation of the foam.

Trial and error means trying a lot. In The Blind Watchmaker, Richard Dawkins brilliantly illustrates this notion of the world without grand design, moving by small incremental random changes. Note a slight disagreement on my part that does not change the story by much: the world, rather, moves by large incremental random changes.

Indeed, we have psychological and intellectual difficulties with trial and error, and with accepting that series of small failures are necessary in life. My colleague Mark Spitznagel understood that we humans have a mental hang-up about failures: “You need to love to lose” was his motto. In fact, the reason I felt immediately at home in America is precisely because American culture encourages the process of failure, unlike the cultures of Europe and Asia where failure is met with stigma and embarrassment. America’s specialty is to take these small risks for the rest of the world, which explains this country’s disproportionate share in innovations. Once established, an idea or a product is later “perfected” over there.

Volatility and Risk of Black Swan

People are often ashamed of losses, so they engage in strategies that produce very little volatility but contain the risk of a large loss – like collecting nickels in front of steamrollers. In Japanese culture, which is ill- adapted to randomness and badly equipped to understand that bad performance can come from bad luck, losses can severely tarnish someone’s reputation. People hate volatility, thus engage in strategies exposed to blowups, leading to occasional suicides after a big loss.

Furthermore, this trade-off between volatility and risk can show up in careers that give the appearance of being stable, like jobs at IBM until the 1990s. When laid off, the employee faces a total void: he is no longer fit for anything else. The same holds for those in protected industries. On the other hand, consultants can have volatile earnings as their clients’ earnings go up and down, but face a lower risk of starvation, since their skills match demand – fluctuat nec mergitur (fluctuates but doesn’t sink). Likewise, dictatorships that do not appear volatile, like, say, Syria or Saudi Arabia, face a larger risk of chaos than, say, Italy, as the latter has been in a state of continual political turmoil since the second war. I learned about this problem from the finance industry, in which we see “conservative” bankers sitting on a pile of dynamite but fooling themselves because their operations seem dull and lacking in volatility.

Barbell Strategy

I am trying here to generalize to real life the notion of the “barbell” strategy I used as a trader, which is as follows. If you know that you are vulnerable to prediction errors, and if you accept that most “risk measures” are flawed, because of the Black Swan, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative. Instead of putting your money in “medium risk” investments (how do you know it is medium risk? by listening to tenure-seeking “experts”?), you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury bills – as safe a class of instruments as you can manage to find on this planet. The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options), preferably venture capital-style portfolios.[43] That way you do not depend on errors of risk management; no Black Swan can hurt you at all, beyond your “floor”, the nest egg that you have in maximally safe investments. Or, equivalently, you can have a speculative portfolio and insure it (if possible) against losses of more than, say, 15 percent. You are “clipping” your incomputable risk, the one that is harmful to you. Instead of having medium risk, you have high risk on one side and no risk on the other. The average will be medium risk but constitutes a positive exposure to the Black Swan. More technically, this can be called a “convex” combination. Let us see how this can be implemented in all aspects of life.

“Nobody Knows Anything”

The legendary screenwriter William Goldman was said to have shouted “Nobody knows anything!” in relation to the prediction of movie sales. Now, the reader may wonder how someone as successful as Goldman can figure out what to do without making predictions. The answer stands perceived business logic on its head. He knew that he could not predict individual events, but he was well aware that the unpredictable, namely a movie turning into a blockbuster, would benefit him immensely.

So the second lesson is more aggressive: you can actually take advantage of the problem of prediction and epistemic arrogance! As a matter of fact, I suspect that the most successful businesses are precisely those that know how to work around inherent unpredictability and even exploit it.

Recall my discussion of the biotech company whose managers understood that the essence of research is in the unknown unknowns. Also, notice how they seized on the “corners”, those free lottery tickets in the world.

Here are the (modest) tricks. But note that the more modest they are, the more effective they will be.

a. First, make a distinction between positive contingencies and negative ones. Learn to distinguish between those human undertakings in which the lack of predictability can be (or has been) extremely beneficial and those where the failure to understand the future caused harm. There are both positive and negative Black Swans. William Goldman was involved in the movies, a positive-Black Swan business. Uncertainty did occasionally pay off there.

A negative-Black Swan business is one where the unexpected can hit hard and hurt severely. If you are in the military, in catastrophe insurance, or in homeland security, you face only downside. Likewise, as we saw in Chapter 7, if you are in banking and lending, surprise outcomes are likely to be negative for you. You lend, and in the best of circumstances you get your loan back – but you may lose all of your money if the borrower defaults. In the event that the borrower enjoys great financial success, he is not likely to offer you an additional dividend.

Aside from the movies, examples of positive-Black Swan businesses are: some segments of publishing, scientific research, and venture capital. In these businesses, you lose small to make big. You have little to lose per book and, for completely unexpected reasons, any given book might take off. The downside is small and easily controlled. The problem with publishers, of course, is that they regularly pay up for books, thus making their upside rather limited and their downside monstrous. (If you pay $10 million for a book, your Black Swan is it not being a bestseller.) Likewise, while technology can carry a great payoff, paying for the hyped-up story, as people did with the dot-com bubble, can make any upside limited and any downside huge. It is the venture capitalist who invested in a speculative company and sold his stake to unimaginative investors who is the beneficiary of the Black Swan, not the “me, too” investors.

In these businesses you are lucky if you don’t know anything – particularly if others don’t know anything either, but aren’t aware of it. And you fare best if you know where your ignorance lies, if you are the only one looking at the unread books, so to speak. This dovetails into the “barbell” strategy of taking maximum exposure to the positive Black Swans while remaining paranoid about the negative ones. For your exposure to the positive Black Swan, you do not need to have any precise understanding of the structure of uncertainty. I find it hard to explain that when you have a very limited loss you need to get as aggressive, as speculative, and sometimes as “unreasonable” as you can be.

Middlebrow thinkers sometimes make the analogy of such strategy with that of collecting “lottery tickets”. It is plain wrong. First, lottery tickets do not have a scalable payoff; there is a known upper limit to what they can deliver. The ludic fallacy applies here – the scalability of real-life payoffs compared to lottery ones makes the payoff