Embrace Black Swans to Avoid Financial Disaster, Urges Taleb

By Mark Gilbert

April 20 (Bloomberg) -- A slump in Chinese stocks on Feb. 27 triggered the worst week 
for U.S. equities in more than four years and the biggest one-day jump in volatility 
ever -- the financial equivalent of a butterfly's flapping wing in New Delhi causing a 
hurricane in North Carolina.

In ``The Black Swan: The Impact of the Highly Improbable,'' Nassim Nicholas Taleb 
argues that we are dangerously blind to the possibility of unlikely events, and 
reluctant to accept their unpredictability when they do occur. It is a seductive 
thesis.

A Black Swan, in Taleb talk, is an incredibly improbable event with a colossal impact, 
be it 9/11 or the rise of Google Inc. Our response to such events is to rationalize 
them, making them appear more predictable than they were, the author argues. In short, 
we kid ourselves.

Our global economy gives ``the appearance of stability'' even as it ``creates 
devastating Black Swans,'' he says. ``We have never before lived under the threat of a 
global collapse. The financial ecology is swelling into gigantic, incestuous, 
bureaucratic banks -- when one falls, they all fall.''

Taleb comes across as a guy who says what he 
likes and likes what he says. He paints himself as a Renaissance man, a polymath as 
conversant in music and literature as he is in mathematics and finance. Abundant 
examples and playful turns of phrase make this a fascinating, challenging read. His 
concept of ``Umberto Eco's Antilibrary,'' where intellectual wealth lies in unread 
books rather than well-thumbed volumes, is a lovely abstraction.

Splashes of Arrogance

His investment fund, Empirica Capital LLC, made him rich enough to spend his time 
contemplating life from ``dilapidated but elegant cafes in regular neighborhoods as 
undiluted with persons of commerce as possible.'' Arrogant splashes like this stain 
more pages than is necessary; I don't imagine Taleb suffers editors gladly.

Taleb has a couple of claims to fame. His 2001 book, ``Fooled by Randomness,'' has been 
published in 18 languages. In April 2002, he was the subject of a Malcolm Gladwell 
profile in the New Yorker magazine that ran to almost 8,000 words, outlining his theory 
that luck plays a huge, unacknowledged role in success for traders and investors.

In his new book, Taleb says 
we're all guilty of confirmation bias, tending to look for things that 
corroborate what we believe to be true.

 We're also victims of the narrative fallacy, ``our predilection for compact 
stories over raw truths.''


Tigers and Dynamite

A casino might look like a business where calculations of risk and probability 
determine success or failure. Yet the MGM Mirage casino in Las Vegas ``spent hundreds 
of millions of dollars on gambling theory and high-tech surveillance, 
while the bulk of the risks came from outside their models,'' Taleb says.

Consider the white tiger that mauled magician Roy Horn of duo Siegfried and Roy at the 
Mirage in October 2003, costing the casino $100 million, Taleb says. Or the disgruntled 
contractor who tried to dynamite the place. One employee failed to file tax returns on 
big-winning gamblers, resulting in ``a monstrous fine,'' while the owner violated 
gambling laws to pay the ransom on his kidnapped daughter.

``The dollar value of these Black Swans, the off-model hits and potential hits, swamp 
the on-model risks by a factor of close to 1,000-to-one,'' he writes.

There's an investment strategy to profit from improbability. ``Be as hyperconservative 
and hyperaggressive as you can instead of being mildly aggressive or conservative,'' 
Taleb advises. ``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.''

Killing the Turkey

The hand can feed the turkey for 1,000 days until, on day 1,001, it wrings the fowl's 
neck for Thanksgiving. The trick is to be the butcher, not the turkey.

``A thousand days cannot prove you right, but one day can prove you to be wrong,'' 
writes Taleb. ``I am not urging you to stop being a fool. Just be a fool in the right 
places.''

With risk measures at or near record lows, including volatility indexes, corporate bond 
defaults, credit spreads and emerging-market yields, Taleb might help you dodge the 
next Black Swan. The book is from Random House (356 pages, $26.95).