Book Review: The Black Swan

Nassim Taleb writes about risk.

His book, The Black Swan, is a warning to those who rely too heavily on academic theories about what is probable. He cites lots of issues with trusting the eggheads, including the stock market crash of ‘87, the blowup of Long Term Capital Management, and the “impossible” collapse of the Soviet Union. He then goes on to make fun of the specific individuals who made these predictions over the course of four-hundred pages or so. It gets the point across quite well.

His main argument is that our education system focuses too much on the predictive power of statistics. The statistics that we are taught in school rely on the “Gaussian” bell curve, where most events fall into the middle of some predictable average.

This is a case of the tail wagging the dog. The Gaussian bell curve has nice mathematics that makes for pretty theories, but it falls down in the real world. He calls this type of thinking “Mediocristan”.

Instead, Taleb says, we should be thinking of the world as primarily driven by high-impact but extremely rare events. He calls this mode of thinking “Extremistan”. Extremistan explains why just a few people hold most of the world’s wealth and why most of the gains in the stock market come from just a few days each decade. If you try to use normal Gaussian statistics to predict things in an Extremistan world you will have a bad time. The rare but important events are called “Black Swans” (hence the name of the book) and are inherently unpredictable. Rather than trying to guess when and where they will happen, you should make sure you are exposed to positive Black Swans and protected from negative ones.

This is basically the entire book. He uses lots of colorful language and some fictional examples to make his point, but if you accept the previous paragraph then you’ve basically got the gist.

Taleb’s writing has a remarkable way of convincing you that most experts are idiots and it’s just you and him against the world. It’s very clever — several times I caught myself nodding and thinking “yes, what fools they are” about people that I have never heard of before. This is intentional. He says it himself:

"You can afford to be compassionate, lax, and courteous if, once in a while, when it is least expected of you, but completely justified, you sue someone, or savage an enemy, just to show that you can walk the walk."

While I’m not convinced that savaging your enemies is an explicit takeaway of the book, there are plenty of anecdotes like this. His anger is somewhat justified. He believes that many of the booms and busts of modern society have come about as a result of the upper class misusing their status as authority figures to enrich themselves while exposing others to undisclosed risk.

While I’m not sure that this is exactly how the modern financial system works, there are some actionable takeaways in the book. For example, he talks about pursuing a “barbell strategy” in investing, where the majority of your assets are held in extremely stable instruments (he mentions Treasury bills) and the remaining 10-15% are put into highly speculative bets with large payoffs. In this way, you avoid being overdependent on large-scale predictions from experts using phony mathematics. Since the future is unpredictable in an Extremistan world, this is the best strategy to maximize your chances for success.

Know how to rank beliefs not according to their plausability but by the harm they may cause.

Taleb considers himself to be a contrarian. Naturally, I was interested when he brought up an event that popular contrarian-billionaire Peter Thiel has also discussed publicly: the fate of Long Term Capital Management, a hedge-fund that used complicated mathematical models to allocate billions of dollars of capital.

Thiel gave a talk in 2018 that was ominously titled “Financial Markets and the Singularity”. In it, Thiel discusses his theory about the cause of the accelerating boom and bust cycles. His conclusion stood out to me because it seems to disagree on the cause that Taleb puts forth for the blowup. From Thiel’s talk:

And some of the busts have also been extraordinarily big. In financial derivative contexts there was the Long Term Capital blow up in 1998. The mathematicians who had priced these financial derivatives estimated that something like the scale of the move on these markets was something that would only happen in one trillion times the history of the universe. And of course, the conventional postmortem on Long Term Capital is that the mathematicians were just wrong and they hadn't done a very good job programming their computers. Obviously, the math must be wrong, but I think that sort of an interesting question will be asked, what if the math was actually right? What if we just had an extraordinary bust?

Contrast this with Taleb’s recollection of the same incident:

Then, during the summer of 1998, a combination of large events, triggered by a Russian financial crisis, took place that lay outside their models. It was a Black Swan. LTCM went bust and almost took down the entire financial system with it, as the exposures were massive. Since their models ruled out the possibility of large deviations, they allowed themselves to take a monstrous amount of risk.

On the surface, these seem to be conflicting viewpoints. But if both Thiel and Taleb are contrarians, and the conventional take is that the economists were wrong, then how can they disagree?

Even though they approach the situation from different perspectives, they are actually saying the same thing. Taleb argues that the financial models relied on assumptions that were invalid in a world dominated by Extremistan events. Thiel reasons that all booms are fueled by speculation that this will be the one event that outweighs all the rest — he calls this “The Singularity” but it’s really just a Black Swan of enormous size.

LTCM thought they were harnessing a positive Black Swan (mathematical models that perfectly allocated capital), but in reality, they were exposing themselves to a negative Black Swan (the collapse of the Russian economy). Thiel’s thesis is that good investors should have an opinion on which Singularity will be the “real one”. Since Extremistan events are so unequal, you can’t afford to miss the few events that matter (remember, the majority of gains in the stock market over the last fifty years have come from just ten days).

If you miss a Black Swan but are right about everything else, you’ve still failed to predict the future. The Black Swan is actually a book about The Singularity. If you’re planning to be around for the end of the world, you might as well be right.