Nassim Taleb on Living with Black Swans

Here is a superb interview of Nassim Taleb (interviewed by his professor at Wharton). He explains how people have misunderstood the concept of black swans.

People think they can predict black swan events which is plains false.

Most people think that they can predict the black swan, that with quantitative sophistication they can get answers. They don’t get the idea that because we can’t predict black swans, then we need to restructure institutions and rethink strategies to be more robust in the face of uncertainty.

People should instead be looking at sources of fragility and make them robust:

The map into this terrain is quite difficult to follow. You have to avoid having things fail too late. You have to avoid debt because debt makes the system more fragile. You have to increase redundancies in some spaces. You have to avoid optimization. That is quite critical for someone who is doing finance to understand because it goes counter to everything you learn in portfolio theory…. I have always been very skeptical of any form of optimization. In the black swan world, optimization isn’t possible. The best you can achieve is a reduction in fragility and greater robustness. You may have heuristics, but not an optimization rule. I hope the message will finally get across because I haven’t succeeded yet. People talk about black swans but they don’t talk about robustness, which is the real lesson of the black swans.

It’s] like saying a bridge is fragile. I can’t predict which truck is going to break it, so I have to look at it more in a structural form — what physicists call the percolation approach. You study the terrain. You don’t study the components. You see in finance, we study the random walk. Physicists study percolation. They study the terrain — not a drunk person walking around — but the evolution of the terrain itself. Everything is dynamic. That is percolation.

And then you learn not to try to predict which truck is going to break that bridge. But you just look at bridges and say, “Oh, this bridge doesn’t have a great foundation. This other one does. And this one needs to be reinforced.” We can do a lot with the notion of robustness.

He says events in middle east were not black swans:

We seem to have had over the last six weeks a number of black swans flying through our global universe. You know a lot about the Middle East. Should the “Arab Spring” of political revolutions in the Middle East and North Africa be considered a black swan?

The events in the Middle East are not black swans. They were predictable to those who know the region well. At most, they were gray swans or perhaps white swans. One of the lessons of “Wild vs. Mild Randomness,” my chapter with Benoit Mandelbrot in your book, is what happens before you go into a period of wild randomness. You will find a long quiet period that is punctuated with absolute total turmoil…. In The Black Swan, I discussed Saudi Arabia as a prime case of the calm before the storm and the Great Moderation [the perceived end of economic volatility due to the creation of 20th century banking laws] in the same breath. I was comparing Italy with Saudi Arabia. Italy is an example of mild randomness in comparison with Saudi Arabia and Syria, which are examples of wild randomness. Italy has had 60 changes in regime in the post-war era, but they are inconsequential…. It is a prime example of noise. It’s very Italian and so it’s elegant noise, but it’s noise nonetheless. In contrast, Saudi Arabia and Syria have had the same regime in place for 40 some years. You may think it is stability, but it’s not. Once you remove the lid, the thing explodes.

The same kind of thing happens in finance. Take the portfolio of banks. The environment seemed very placid — the Great Moderation — and then the thing explodes.

He says shocks are good for the system and we need  a oil shock. Then only people will learn not to live beyond their means:

I think that an oil shock would be very good because we need to be trained to finally give up on these stupid cars. We have so many alternative sources, and people are too lazy. We need to enhance anti-fragility in this area. You can move from wild randomness into mild randomness by creating some. It is like hormesis: You give someone a little bit of poison and they get stronger. Economic life gets stronger not with bailouts, but with bankruptcies.

Evolution works not with bailouts — there are no bailouts in nature — but with competition and natural selection. So you need to have some stressors and to use stressors to strengthen the system. We have not been stressed enough about the oil crisis, and it has led to a horrible situation in which the U.S. government is playing a hypocritical role driven by humanitarian forces in Libya, but at the same time supporting the Saudi royal family, essentially one tribe running a place — even giving its name to it. It is the most unstable place and the most backward of regimes in the world — all in the name of oil security.

So you realize that you have some schizophrenia as far as how a lot of Western governments are behaving. So we need a little bit of oil shock….

Read the whole thing. He talks about growing moral hazards, bankers, options (he was an option trader) etc in his witty critcizing style. Learning with  entertainment.

One Response to “Nassim Taleb on Living with Black Swans”

  1. Team America: World Police « azizonomics Says:

    […] The questions that we have no ask are not limited to whether or not this is a “good” system. The real questions that we have to ask are is this a robust system, is this a sustainable system — and if not, we have to ask if there is a viable alternative. What is robustness? From Nassim Nicholas Taleb: […]

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