Friday, May 20, 2011

Black Swan Theory revisited

I hear a lot of talk about Black Swans in my cbox these days. It's getting to be pretty cliche because of the constant usage. Just what is a Black Swan? Black Swan theory (capitalized to avoid the reference to actual swans that are black) is a phenomenon, popularized by one of my favourite author, Nassim Nicolas Taleb. Black Swan theory is characterized by 4 things - it's an event that is highly improbable and incalculable probability, highly consequential and finally the event can be rationalized by hindsight after the event.

There's a lot of interesting things about Black Swan theory that I've already talked about when I read the books a few years ago. I thought it's a great idea for readers to read it for themselves. Nassim Nicholas Taleb wrote two books on his pet topic, "Fooled by Randomness" and "The Black Swan". I think that the first book is a better read than the second one, though the second one is laced with more substance. It's the easy readability of his first book that endeared me to his astute observations about the world we lived in.

Here's a few links that I wrote in my past entries:

The black swan


 Living life in an uncertain world

 There are a few things that I'd always remembered after reading his books. A good book will make always leave some indelible marks after reading, such that you can never see life again in the same light. Here's a few thoughts that still stick to my mind:

Incalculable, improbable, consequential & retrospective

1. Do not confuse absence of evidence for the evidence of absence.

It's hard not to mix up a rare and low probability event by a non-event. Not seeing a swan that is black (absence of evidence) does not mean that there are no black swans (evidence of absence). Well, it could be that there are really no black swans in the entire universe or simply that you haven't come across it yet. Likewise, a 100 yr old man who had never died before (absence of evidence) cannot proudly boast that since he had not lived a day where he had died in the past 100 yrs, he's going to live for another 100 yrs (evidence of absence). Here, a single occurrence of a rare event will render all theories that came before it totally flabbergasted, thus the management of rare events plays a highly important role in everyday life.

In essence, we have to be open minded and embrace possibilities instead of being trapped in the framework of the past.

2. It is impossible to tell in advance whether an event has yet to happen or it can never happen.

This is linked to the first point because it's hard not to get mixed up between a zero probability event and a event that has low probability. As the local posters by the police had mentioned, low crime doesn't mean no crime. If we have a pack of 500 cards, and after drawing 499 cards, we are still drawing to get a queen of hearts, do we say that there isn't a queen of hearts or simply that it has a low probability of occurrence? It's just impossible to tell in advance whether an event has yet to happen or it can never happen.

Again, this calls for one to be open minded and really requires one to have the ability to accept possibilities, even strange ones that nobody had thought about. As Albert Einstein put it so succinctly, a genius is a person who dreams of snow while living in a desert. 

3. Black Swan events have positive AND negative connotations

A lot of people attributed a negative connotation to Black Swan events. It can be the financial crisis (bad), it can be a spate of natural disasters in Japan (bad) or it can be a sudden diagnosis of cancer (bad). However, if you go by the definition, highly consequential events can either be good or bad. If you feed a chicken all the way when it's just a little chick, the chicken will learn to trust you. It may learn that you are its provider of food and you will take care of it. However, when the chicken is of age, you slaughter it for food. To the chicken, it's a negative Black Swan event.

(This brings to mind another interesting aspect. A Black Swan event is a relative term. If you're the person who reared the chicken for food, there is no doubt in your mind that once the chicken reaches a certain age, you'll slaughter it for food. However, in the eyes of the chicken, nothing is further from the truth. The many years that the chicken has lived peacefully without you slaughtering it cannot be misconstrued as the evidence of absence of slaughter.)

Similarly, I can give other examples of a person striking it rich with a ticket lottery. Or a chance encounter with someone who loves your singing so much that he's willing to sign you up as a singer.

To prepare for Black Swan events, we must be prepared for both the good ones, as well as the bad ones. The key is to limit exposure to the bad ones while maximizing exposure to the good ones. We should all work hard to expose ourselves to opportunities, even those that looks like opportunities (again, I cannot seem to emphasize this enough - be open minded!). You'll never know if your next break may come from helping an innocent bystander to pick up the book that he dropped on the floor, or to strike up a conversation with the person sitting next to you on the lonely road to the office during peak hour (interestingly, a crowded MRT can be a very lonely journey).

To prove my point, I wish to highlight the fact that many of the world's greatest discoveries or inventions are made when the person involved is not actively searching for it. Penicillin, the wonder antibiotic, was discovered by a very open minded researcher in a very fortunate accident. America was discovered when a trip was made to look for India (trivial: hence Native Americans are called Indians). A way to measure the density of irregular objects was likewise made when a certain someone is relaxing in a bathtub, possibly after trying to solve a problem deliberately.

So there, that's something to digest and think about.

*This article is contributed to IM$avvy financial portal, which is managed by Central Provident Fund Board and supported by MoneySense. This site has a noble aim of promoting financial literacy to the general population.


Temperament said...

Hi LP,
The Black Swans theory is very cheem.
For me always try to remember anything can happen in life; especially in the stock markets. So always be prepared.But since we don't know what is going to happen in the future, how and what we are going to prepared? Any idea?

Anonymous said...

hi LP , great post as usual. U DREW THE BLACK SWAN PIC?? awesome...u r an artist dude....

lots of love,

la papillion said...

Hi temperament,

I think to be prepared is to have good money management. Here's a few ways that I can come up with:

1. Do not overinvest in a counter even though you're 100% sure that it'll make money.

2. Always have cash ready to take advantage of cheap sale when it happens.

3. Have a list of things that you want to buy on the market, so that when the opportunity presents itself, you won't be at a fix.

4. I think bro8888's advice is very applicable - sell slowly and buy slowly.

Any add on from your side?

la papillion said...

Hi 3m,

Long time no see...where have you been? Busy at work?

No lah, I didn't draw that picture :) But I loved it, hence I clipped it from the web.

Temperament said...

Hi LP,
100% agree with you.I think the clique sayings, "hope for the best, prepare for the worst", "in time of prosperity prepare for famine", "in time of peace, prepare for war", and many, many more cliques. i think all these cliques must have something to do with the so called "Black Swan". Actually i think most people know long ago life is never "predictable".
You will never even know exactly what's going to happen next second, next minutes, true?
So enjoy life now to the extend you are comfortable with. Enjoy.