Black Swans

Let me second Brendan Nyhan's recommendation of Nassim Nicholas Taleb's The Black Swan: The Impact of the Highly Improbable as providing useful context for understanding the ongoing financial crisis that, on some level, was caused by people being overconfident in their ability to asses risk.

The main point is that people tend to neglect the possibility of something highly improbable happening because it is, after all, highly improbable. But the odds that something or other that's highly improbable will happen are actually pretty good. And these highly improbable events can have huge impacts. The book's wide-ranging but the author's background is in finance and he illustrates with plenty of examples from that world.

Comments

"Now, a few words on looking for things. When you go looking for something specific, your chances of finding it are very bad. Because of all the things in the world, you're only looking for one of them. When you go looking for anything at all, your chances of finding it are very good. Because of all the things in the world, you're sure to find some of them."

Posted by Jeffrey Davis | March 18, 2008 8:48 AM

I think if you actually want the finance perspective a bit more, check out his first book Fooled by Randomness. It's definitely more relevant, and filled with personal trading anecdotes, along with a nice heaping of bitterness.

It's a bit hard to get through, with all the self-promotion and all, but he has a good point and he is probably the most well known and interesting advocate of it.

Posted by alex | March 18, 2008 8:55 AM

Intelligence - the ability to evaluate the improbability of unlikely events.

Wisdom - the knowledge that the sum of the improbabilities of unlikely events leads to a probability.

Posted by Scott Ferguson | March 18, 2008 9:03 AM

If that is indeed a descriptor of many of these peoples' psychological context, more importantly this delusion was massively indulged up by a public, political ideology that anyone who doubted these individuals' and companies' ability to intuit and calculate financial probability beyond any reasonable control of risk was some old-fashioned fringe-y liberal type who hated entrepreneurship and wanted to ruin our boomiest boom of all time, and which also held / holds that any attempt to control this were oppressive regulations which were so early 20th century.

Posted by El Cid | March 18, 2008 9:03 AM

This is the same Nassim Taleb who wrote, in the preface to _Dynamic Hedging_, that "I believed in a greater uncertainty principle (more acute than Heisenberg's) that largely invalidates social science theories based on physics-like methodology and weakens the notion of modeling outsided of the natural sciences." Right?

Taleb's - like Soros' - point is really simple: there are positive-feedback dynamics in markets that can result in wild mispricings, and subsequent sharp crashes. That he needs to wrap this simple insight in such grandiose language makes it very difficult for me to take him seriously as a writer or a thinker.

Worse, since he explicitly disclaims a theory about how bubbles form, and how to spot them when they are forming, the grandiose language is wrapped around almost non-existent content.

Neither Soros nor Taleb can teach anyone how to make money. The difference between them is that Soros has actually made a huge amount of money betting in the markets, while Taleb has made most of his money selling books and lecturing about his money-making theories.

Malcolm Gladwell must love him.

Posted by Noah Millman | March 18, 2008 9:04 AM

I couldn't make it through Fooled By Randomness. Too little meat, too much of Taleb's repellent personality.

Invoking the Black Swan in the subprime mess is odd, however, given that so many commentators have been warning about the level of risk involved with extremely leveraged hedge funds and evaporating risk premiums. The only people who didn't see this coming were the people who were making huge fees by selling their supposedly "low risk" models.

Posted by Helter | March 18, 2008 9:06 AM

An excellent discussion along these lines is Richard Feynman's individual addendum to the report on the Challenger accident, http://www.fotuva.org/feynman/challenger-appendix.html

He begins:

It appears that there are enormous differences of opinion as to the probability of a failure with loss of vehicle and of human life. The estimates range from roughly 1 in 100 to 1 in 100,000. The higher figures come from the working engineers, and the very low figures from management... Since 1 part in 100,000 would imply that one could put a Shuttle up each day for 300 years expecting to lose only one, we could properly ask "What is the cause of management's fantastic faith in the machinery?"

and he concludes:

"For a successful technology, reality must take precedence over public relations, for nature cannot be fooled."

When you read it, you will see the same sort of self-deluded under-estimation of risk that characterizes the current financial crisis.

Posted by Bloix | March 18, 2008 9:07 AM

Is highly improbable to believe that one can reasonably expect repayment of money lent to people unable to pay it back unless the asset they used the money to buy increases in value by 20% a year after already increasing by upwards of 100% in the prior couple of years. I think not. It would have been highly improbable if the loans were paid back. What happened was entirely predicable.

What is highly improbable is we believe that the many people in the Federal Reserve and U.S. Government who did nothing to prevent this are now capable of taking steps to correct it.

Posted by Matt Connolly | March 18, 2008 9:14 AM

Manias, Panics and Crashes by Charles P. Kindleberger is the great modern work on financial lunacy; its Victorian forefather, Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, is online.

Posted by pseudonymous in nc | March 18, 2008 9:16 AM

Methods for assessing risk are notoriously inaccurate. A common method in engineering studies for assessing the probability that a structure will fail is to multiply the failure probabilities of the separate parts. An engineer I knew once pointed out that this would be valid only if all the parts were disconnected and lying on shelves in a warehouse.

Posted by MattF | March 18, 2008 9:28 AM

Plus, I'll nth those saying that the prospect of a calamitous fuckup of the markets was highly predictable; what was less predictable was the fallout pattern.

You had all of the classic elements: the bigger fool paradigm, the expansion of ancillary and peripheral markets around the boom, the attachment of swindlers to the boom; and so on.

The overriding narrative here seems to be that Persons of Quality had time to flip, flop, flap, took their equity from the mortgage ATM, then headed for the 30-yr fixed, leaving the plebs to take on what was left.

That's to say, the perception is still that such bubbles are not necessarily to be avoided: if the Ps of Q can exploit them, stay personally untouched, and the wider consequences are sufficiently mitigated to avoid their being tarred-and-feathered, then bring on the next one.

One presumes that Alan Greenspan will not be telling Andrea Mitchell to sign up with the Emperor's Club in order to cover the mortgage(s). As Atrios noted, the bobbleheads of mass media discourse are all rather well off.

Posted by pseudonymous in nc | March 18, 2008 9:30 AM

MY writes:

But the odds that something or other that's highly improbable will happen are actually pretty good.

Yep. That's why Schock Doctrine is a viable business model. Just be well capitalized and opportunistic.

Posted by lambert strether | March 18, 2008 9:34 AM

I'm sorry, but this was entirely probable. This was predictable. Many people predicted this. The Economist, which you claim to enjoy, predicted this. We had an unprecedented housing boom, and thus we were facing an unprecedented housing crash. And yet people are standing around looking at each other with blank faces saying "Wha?"

I guess you'll be surprised when the audits of Fannie Mae and Freddie Mac come back too?

Posted by freddiemac | March 18, 2008 9:41 AM

The Discovery Channel told me that rogue waves happen for the very same reason.

Posted by ben | March 18, 2008 9:44 AM

Taleb is best read in the voice of Otto from Fish Called Wanda. Otherwise, unreadable. "I am not like the others, the fools. I Read Poetry." Pretty sure that's close to a direct quote.

Posted by david | March 18, 2008 9:49 AM

I'm sorry, but this was entirely probable. This was predictable. Many people predicted this.

The only unpredictable element was, in essence, the personal assessment of 'can I get in and out before this goes tits-up?'

Individual economic decisions were being made with an eye on claiming a seat on the last lifeboat. We knew the ship was going down, just not how many lifeboats there were.

Posted by pseudonymous in nc | March 18, 2008 9:52 AM

This book sounds excellent because, along with the book "The Tipping Point", there is reason to be more supportive of so-called "worst case" scenarios with reference to climate change. Scientists are already surprised at some of the rapid declines in the Antarctic and Artic regions. When I hear people rag on Al Gore for using "worst case" scenarios, I try to explain this, but usually it seems too theoretical to such folks.

Posted by Mitchell Freedman | March 18, 2008 10:10 AM

This book sounds excellent because, along with the book "The Tipping Point", there is reason to be more supportive of so-called "worst case" scenarios with reference to climate change. Scientists are already surprised at some of the rapid declines in the Antarctic and Artic regions. When I hear people rag on Al Gore for using "worst case" scenarios, I try to explain this, but usually it seems too theoretical to such folks.

Posted by Mitchell Freedman | March 18, 2008 10:10 AM

It looks like there's a thin line between this book, and the "1% doctrine."

Posted by Nordy | March 18, 2008 10:16 AM

This is noy a Black Swan event. Not merely predictable, in some form or other, at some time or another, financial bubbles and panics are inevitable under laizzes faire capitalism, to the degree the economy is not balanced by a welfare state that eliminates the concentrations of wealth that guarantee speculation.

See:Minsky, Herman. Or Keynes.

It is, IMO, also a result of the "Great Moderation" and intended by Greenspan for his pernicious purposes.

Posted by bob mcmanus | March 18, 2008 10:19 AM

Taleb's Fooled by Randomness was the worst written book I've ever read. I can't imagine his writing skills (or ridiculous bravado) have improved enough to make me want to pick up the Black Swan. Seriously...how could anyone -- anyone!!!! -- enjoy that buffoon's writing?

Posted by Ryan | March 18, 2008 10:23 AM

I'm sorry, but this was entirely probable. This was predictable. Many people predicted this.

Many people predicted the housing market was a bubble that would come back to earth. Very few people predicted that it would bring the entire financial system with it.

Most people had a vague belief that new-fangled financial instruments like CDOs and CDSs would efficiently allocate--and theoretically minimize--the risk in the system. In fact, the opposite seems to be true.

Posted by right | March 18, 2008 10:27 AM

This is a classic example of fighting "the last war." "Black Swan" is a great book if you're interested in understanding how hedge funds like LTCM and others imploded in a huge ball of flame. Their models simply didn't account for highly improbably events occuring.

The current crisis is more about a demonstration in how long unsustainable circumstances can be sustained. Everyone "knows" that you can't continue massive trade deficits without devaluing your currency. Everyone "knows" that borrowing money against the rising value of real estate to leverage investments in real estate to take advantage of their rising value is an unsustainable bubble, but these sustained themselves for so long that it made believers out of people. It wasn't imporbably events that occured that people didn't expect-- what occured were inevitable events that people simply forgot about.

Posted by Tyro | March 18, 2008 10:31 AM

I read both Fooled by Randomness and The Black Swan in the past year. I thought the latter was by far the better book, and worth reading even if you've read the first (the parts where he repeats stuff from the first book are fairly self-contained and can be skipped over). It's the more interesting for being more wide-ranging, although the flip side of that it is that it is quite unfocused. To be sure, the guy has, um, no self-esteem issues at all, but that's hardly the worst thing in the world.

Posted by Incompetence Dodger | March 18, 2008 10:52 AM

An excellent discussion along these lines is Richard Feynman's individual addendum to the report on the Challenger accident

Yep. Feynman was probably the greatest theoretical physicist of the second half of the twentieth century.

And the average physicist is probably an SD or two brighter than the average economist.

While your average economist might be an SD or so smarter than people like Gladwell, Cramer, and their friends who write all those silly books or dominate the TV airwaves. But these are the sort of people who influence "the masses" in their economic behavior.

Which is how we've gotten into the mess we have.

I think as RSH might we, we have bands of baboons being led by chimpanzees...

Posted by RKU | March 18, 2008 12:03 PM

RKU, I'm an econ major at Chicago where our economists are supposedly the most brilliant in the world.

My brother and sister-in-law are physics professors at the University of Michigan.

I beg to differ with your use of "probably"; you should have said "at least".

Posted by Greg | March 18, 2008 12:24 PM

To understand Taleb, it helps to understand that he grew up a privileged child in Lebanon. When he was a teenager, a long-standing rift in his culture became a shooting war. Close relatives assured again and again that it would be over in a few days. It went on for decades; in some ways, it's never stopped.

This perspective may or may not be exactly applicable to yesterday's crisis, but in our country, which has been insulated from disaster from decades, the idea of the black swan deserves attention.

For those interested in seeing how "non-Gaussian" analysis might apply to climate change, please take a look:

http://achangeinthewind.typepad.com/achangeinthewind/2007/11/black-swan-sigh.html

Posted by Kit Stolz | March 18, 2008 12:28 PM

"Not merely predictable, in some form or other, at some time or another, financial bubbles and panics are inevitable under laizzes faire capitalism, to the degree the economy is not balanced by a welfare state that eliminates the concentrations of wealth that guarantee speculation."

"Concentrations of wealth" don't fuel speculation. The real estate bubble was driven mostly by greedy and stupid middle class folks buying second homes for investment purposes with no money down -- Bill Gates and Warren Buffett weren't doing this. Similarly, the dot-com bubble was driven mostly by greedy and stupid middle class folks buying internet stocks on margin. In both cases, of course, Wall Street facilitated the bubbles, but most of the speculators were us or our neighbors.

In the case of the real estate and credit bubble and bust in particular, none of it would have happened if the welfare state hadn't created and stoked the secondary market for mortgages with the massive government-sponsored entities (GSEs) like Fannie Mae and Freddie Mac. And Wall Street is currently taking the biggest hit from the bust so far.

Posted by Fred | March 18, 2008 1:54 PM

"... The real estate bubble was driven mostly by greedy and stupid middle class folks buying second homes for investment purposes with no money down -- ..."

No, the problem was driven by the lenders not the borrowers.

Posted by James B. Shearer | March 18, 2008 3:25 PM

Black Swan, Fooled by Randomness are good books, although a bit heavy with hot headed diatribes.

A far better book, I think, is "Ubiquity: Why Catastrophes Happen" by March Buchanan. It focuses much more on naturaly/scientific phenomenom as a starting point, then applies the lessons to more social structures.

The main point of the book (IMHO) is that it's human nature, when there's a big catastrophe, to look for an equivalently big trigger. But recent scientific research suggests that the size of the consequence is unrelated to the size of the trigger. For example, whether an avalanche is small or not; whether a wildfire burns a few acres or thousands; whether an earthquake is unfelt or devastating; is unrelated to the trigger.

Interesting topic.

Posted by WallStreeter | March 18, 2008 6:25 PM

I found "Black Swan" almost unreadable. Taleb's writing seems to be an exercise in communicating to the reader how brilliant, handsome, brave, gritty, and wonderful Naseem Taleb is. The book is marred by grotesquely self-aggrandizing personal narratives that (barely) serve to demonstrate his main arguments. The very fact that the book begins, not with a discussion of Black Swans, but with a long-winded expose of Taleb's youthful, intellectual brilliance and profound bravery in war-torn Lebanon (reading philosophy by lamplight while the mortars rained down overhead) drives home how nauseating the book is. It's rare to have a writing style so odious it actually causes the reader to hate you.

Posted by K. Larson | March 19, 2008 12:35 AM

"I think as RSH might we, we have bands of baboons being led by chimpanzees..."

Yup.

If you look at the Austrian Economics school people, and that does not include Greenspan despite Ayn Rand's early infatuation, it was clear that sooner or later ever expanding false credit was going to hit a wall.

Back in the 70's, people like Harry Browne predicted either a depression or a hyper-inflation. After Reagan actually had the balls to force the inflation rate down, Browne admitted that that was the last thing he expected to happen - a politician willing to take the heat for reducing the threat of either outcome.

But of course that didn't last.

I think one problem with predicting this outcome was because a lot of people simply didn't comprehend the new credit instruments. It was like the software industry. They pushed something complicated beyond its functionality or reliability without understanding the possible risks.

Call this recession the "Windows Vista recession". Just as Gates' new operating system is a bloated dog with numerous problems, so is the financial industry at this point.

Now the chickens come home to roost. By the estimates of a lot of bears, this is going to be the worst recession in fifty years. And some have started talking about a "Second Depression." I've seen estimates that at least ten percent of the total wealth of the country is going to be wiped out over the next two or three years.

And there is no "bail-out". Without a thorough cleaning out of the bad investments - a full, thorough economic correction - things will just get worse later. According to many analysts, much of the 1930's Depression was prolonged by the actions of the government in attempting to control the worst effects.

Posted by Richard Steven Hack | March 19, 2008 2:10 AM