Black Swan 101: Beware The Highly Improbable
Yesterday, while hiking Muir Woods I saw a man trip and fall head first down a pretty steep hill.
Don’t worry. He’s fine (miraculously). Luckily, there were many people around who saw everything and rushed down to help him get out.
However, this unlikely event reminded me of a popular idea in finance.
That idea is known as The Black Swan.
Thanks to this blog post, you’ll understand everything you need to know about Taleb’s Black Swan (and thank me in the form of tweets 😊 you know I love those).
So let’s get going.
What Is A Black Swan?
First, a little history lesson.
A few centuries ago, Europeans believed black swans (the bird) didn’t exist.
That was until 1697, when Dutch explorers were adventuring in Australia and randomly found (you guessed it) a black swan!
“Wow… So everyone was wrong?”
You know what this means? That people tend to believe something is impossible until it happens.
Fast forward to 2007, Nassim took this black swan metaphor and ran with it. But instead of referring to birds, he referred to the idea of random and extreme events.
Here’s how he summarized it:
“What we call here a Black Swan […] is an event with the following three attributes.
First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility.
Second, it carries an extreme impact (unlike the bird).
Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.” — Nassim Nicholas Taleb
Here’s an easy way to summarize the Black Swan:
- It’s rare and unexpected (you must be a sucker for it).
- After it happens, the impact is extreme.
- After it happens, people explain/ predict it (but not before).
Want a recent example of a Black Swan? Donald Trump winning the election.
- Before his victory, almost no one thought he’d win (some said he had a 4% chance of winning).
- His victory was a shock all around the world (still is).
- After his victory, everyone suddenly said they “always knew” he had a chance (but not before). Even CNN gave 24 theories as to why he won.
The Black Swan strikes again.
Sidenote: I should add that the Black Swan is unpredictable depending on the observer. For example: 9/11 was a Black Swan to its victims, but not to the perpetrators. Thanksgiving is a Black Swan for turkeys, but not for butchers.
Mediocristan or Extremistan: Where Does The Black Swan Live?
This is one of the best mental models I learned from Nassim.
You can think of Mediocristan as the land where things are mundane, obvious and predictable. e.g.: If you have a normal job and make a normal income, you know that no singular event will suddenly make you rich. It will take years of saving and investing, day by day.
You can think of Extremistan as the land where things are highly volatile, accidental, and unpredictable. This can be good or bad. e.g.: If you take all your savings and bet on Bitcoin, you can lose it all or become very rich in a single minute.
Where should you be? I like the idea of having one foot (with most of my weight) in Medriocristan and the other in Extremistan.
Take finance for example. I always plan to have 90% of my money in Mediocristan and 10% in Extremistan.
“Why bother having a foot in Extremistan?”
Because most great/ life-changing events come from Extremistan. By definition, you can’t plan them.
- Columbus wanted to find a better route to India, and accidentally found America.
- Scientists wanted a better hypertension drug, and accidentally invented Viagra.
- Alexander Fleming left out a petri dish in his lab, and accidentally discovered penicillin.
Sidenote: In fact, Arthur Koestler wrote a whole book about people stumbling upon great things. I haven’t read it yet, but really want to. It’s titled “The Sleepwalkers.”
The idea is to put yourself in situations where these “positive Black Swans” can happen. This will never happen in Mediocristan, only Extremistan.
“Luck is far more egalitarian than even intelligence.” — Nassim Nicholas Taleb
Sidenote: I am not recommending going all in on Extremistan. A Black Swan can be extremely positive or extremely negative. Yes, you could win big. But you could also lose everything. Remember that.
How To Prepare For A Black Swan
I always cringe when I see articles that say things like “One of these 3 ‘black swans’ will likely trigger a global recession by end of 2018.”
Why? Because as I said before, you cannot predict a Black Swan.
“Do not try to predict precise Black Swans — it tends to make you more vulnerable to the ones you did not predict.” — Nassim Nicholas Taleb
“Yeah but you also said that Black Swans are only unpredictable depending on the observer. So, maybe the Business Insider article is right.”
True. But if that’s the case, there aren’t only 3 things you could worry about. There’s an infinite number!
- What if North Korea nukes us?
- What if global warming melts the North Pole and we all drown?
- What if a giant asteroid hits us?
- What if there’s a major Facebook glitch?
Beware Of Pascal’s Scams
The name comes from the philosopher Blaise Pascal. He had a famous argument that went something like this:
“I don’t know if God exists. However, if he does exist I have nothing to gain from being an atheist (but I have a lot to lose). Hence, this is why I believe in God.”
This argument applies to all sorts of “worst-case scenarios” (asteroid crash, zombie apocalypse, global warming, terrorist attacks, North Korea nuke, etc… etc…).
The problem is you can waste a lot of time (and money) worrying about/ preparing for these scenarios.
Here’s why Nick Szabo tells you to be careful before acting on any of these:
- There’s usually no feasible way to distinguish between the very improbable (1 in 1,000) and the extremely improbable (1 in 1Billion).
- It’s very likely you’re either overestimating or underestimating the consequences.
- There is no clear way to falsify these big predictions (they have an “unknown unknown” nature).
“Stop throwing around long odds and dreaming of big consequences as if you are onto something profound.
If you can’t gather the information needed to reduce the uncertainties, and if you can’t suggest experiments to make the hope or worry falsifiable, stop nightmaring or daydreaming already.
Also, shut up and stop trying to convince the rest of us to join you in wasting our time hoping or worrying about these fantasies.
Try spending more time learning about what has actually happened in the real world. That study, too, has its uncertainties, but they are up to infinitely smaller.” — Nick Szabo
Sidenote: Faithful to these “worst-case scenarios,” people ask me how can I trust Vanguard so much. JL Collins answered this question in a post aptly titled “What if Vanguard gets nuked?”
Now you know there’s no such thing as “Black-Swan-Proof.”
I’ll repeat. There’s no such thing as “Black-Swan-Proof.”
However, being “Black-Swan-Robust” is good enough.
“What does this mean?”
It means you don’t look at all the ways in which you can survive one specific Black Swan. Instead, make sure that if any Black Swan happens, you’ll be ok.
Here are a few ways to survive an economic crash:
- Have no debt.
- Have little to lose, I recommend Minimalism (that way, even if your apartment burns down you can buy everything again the next day). If you own a bunch of things that cost half your savings, a fire or robbery could ruin your life.
- Learn to live on as little as possible.
- Don’t put all your eggs in one basket. This is why I recommend Index Funds.
- Have a loooong-term view. If you look at the stock market’s last 5 years, investing looks like an easy thing to do. But this is a mirage. Instead, look at the last 100+ years. That way, you’ll see patterns that happen over and over again (and you can prepare). History is a great teacher if you zoom out far enough.
- Have several sources of income.
These are just a few examples that almost guarantee you’ll never go bankrupt, no matter what singular event happens.
This way, you’re not preparing for a specific Black Swan. But should anything bad happen to the economy, you’ll be fine.
“Black Swans being unpredictable, we need to adjust to their existence (rather than naïvely try to predict them).” — Nassim Nicholas Taleb
Final Note — Just Enjoy Life!
Yes, the idea of something highly improbable happening is scary.
Don’t let that cripple you.
Most importantly, don’t let anyone take your money because you fear things like a zombie apocalypse, the collapse of Wall Street, or nuclear war.
So far, every single dollar spent on those events has been wasted.
Even if one of them happens, you odds of predicting the right one are infinitesimal.
Instead, I recommend a healthy dose of positivity.
I’ll let Nassim end this letter for me:
“Imagine a speck of dust next to a planet a billion times the size of the earth. The speck of dust represents the odds in favor of your being born; the huge planet would be the odds against it. So stop sweating the small stuff.” — Nassim Nicholas Taleb
Sidenote: Speaking of positivity, I highly recommend following Nassim on Twitter. Wait for him to debate someone (it’s bound to happen). Trust me, you’ll laugh.
And that’s it for today!
Today, you learned:
- What is a Black Swan.
- Where does the Black Swan live.
- Why you should beware of “Pascal’s scams”.
- How to be “Black-Swan-Robust” (especially financially).
- And don’t worry, be happy!
See you next week (follow the series here to be notified).
Thanks for reading! 😊 If you enjoyed it, test how many times can you hit 👏 in 5 seconds. It’s great cardio for your fingers AND will help other people see the story.
Since I write about finance, legal jargon is obligatory (because the guys in suits made me). Before following any of my advice, read this disclaimer.