Failure to understand Black Swan leads to fallacious thinking

December 29th, 2007

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As we talk to more and more people, we encounter a very frequent lack of understanding of Black Swans (for those who wants to learn more about Black Swans in detail, we recommend this book: The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb). As a result, many people have this erroneous belief that contrarians are predictors of gloom and doom. The more entrenched this lack of understanding (of Black Swans) is, the deeper the fallacy one will fall into. This lack of understanding will degrade the quality of one’s thinking, which can translate to severe financial loss when investing.

Today, we will again attack the stubborn entrenchment of this conception black hole.

First, let’s recall the parable of the turkey in our previous article, How the folks in the finance/economics industry became turkeys?Part 1: Parable of the turkey:

Let?s say you are a turkey. Ever since you were born, humans had always fed you, took care of you and ensured that you were healthy and fat. In all your long life of 1000 days, humans were always your friend. Therefore, you forecast that the next 1000 days will be like the average of the past 1000 days?great care under the hands of your human friends. Life has always been good and you see no reason for otherwise in the future…

Then on the 1001st day of your life, it was the eve of Thanksgiving Day. By Thanksgiving Day, you had became a meal for humans.

Sad story. But to that poor turkey, the eve of the Thanksgiving day is the day of the Black Swan event.

Again, what is a Black Swan event? A Black Swan event is one which is:

  1. Highly unlikely (i.e. very unlikely based on statistical probability)
  2. Colossal impact

For that turkey, being slaughtered on Thanksgiving Day eve is a Black Swan event because:

  1. Based on statistical probability, the chances of being slaughtered is ZERO
  2. The impact spells the end of everything for that turkey

For us, we can laugh at that turkey because our infinitely better wisdom and vastly greater experience tells us that a turkey being slaughtered on Thanksgiving Day eve is nothing new.

For this reason, that is why we delve more on the big picture and economic history and get mired less on minute statistics and detailed numbers. In technically philosophical terms, it means we are taking on a meta-view i.e. we are taking on a view of our view. At times, this means we have to expand our circle of understanding and venture outside of finance, investing and economics into fields such as psychology, politics and history. The broader our circle of wisdom and experience (that includes borrowed experience from a study of history), the less vulnerable we will be to being caught out like that turkey.

Next, why is it that people get caught out by Black Swans?

Let us quote page 140-141 of The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb:

Epistemic arrogance bears a double effect: we overestimate what we know, and underestimate uncertainty, by compressing the range of possible uncertain states (i.e. by reduce the space of the unknown).

I remind the reader that I am not testing how much people know, but assessing the difference between what people actually know and how much they think they know.

What do disasters such as the sub-prime crisis, probable collapse of Centro, collapse of Basis fund have in common? The common defense we hear is, “We didn’t expect it!” Those ‘experts’ often use technically sounding words like “six-sigma” to describe such unexpected events. In reality, they were just like the turkey: they think they know a lot when in reality, they know very little. That is, as what Taleb said, “compressing the range of possible uncertain states.” As a result, they were caught out by the unknown unknowns, just like the turkey. That is why economic and financial experts’ forecasts are often unreliable- in their models, the unknown unknowns do not exist and their forecasts depend on the non-existence of the unknown unknowns to be accurate. But in real life, unknown unknowns often appears unexpectedly, which serve to expose how much these experts do not know.

Now, back to some people’s erroneous belief that we are predictors of gloom and doom.

First, as contrarians, we are not in the business of prediction. Rather, we prepare for Black Swans. To give yourself an idea why such preparation is important, ask yourself this question: Why do parachutists pack a second reserve parachute? Since the statistical probability of a parachute failure is extremely low, does that mean we should completely ignore such a possibility (of the primary parachute not opening)? Therefore, those people who fallaciously believe that preparing for Black Swans is ‘predicting’ is like believing that the parachutist who packs a reserve parachute is ‘predicting’ that his/her primary parachute will fail. Here, as you may notice, we explore the possibilities of how things may go wrong, which is far from ‘predicting’ that things will go wrong. By doing that, we are pushing the boundaries of the unknown unknowns further and further away. The unknown unknowns are where Black Swans occurs. Also, it is not possible to explore all possibilities. Therefore, we concentrate on those that are going to have colossal impact.

To end it all, remember this: there is a difference between prediction and preparing (and even profiting) from Black Swans.