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#FRM Tutorial: Black Swans

March 11, 2010
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#FRM Black Swans

What Does Black Swan Mean?

A Black Swan is an event or occurrence that varies from what is generally expected of a situation and which is be extremely difficult to predict. Black Swan Events were described by Nassim Nicholas Taleb in his book The Black Swan published in 2007. He is a finance professor and former Wall Street trader. He used "The Black Swan Theory" to explain the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations.

Characteristics of a Black Swan Event:

  1. The event is a surprise (to the observer)
  2. The event has a major impact
  3. After the fact, the event is rationalized by hindsight, as if it had been expected.

Ten Principles for a Black Swan Robust World:

Taleb enumerates ten principles for building systems that are robust to Black Swan Events:

  1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks and hence the most fragile become the biggest
  2. No socialization of losses and privatization of gains. Whatever may need to be bailed out should be nationalized; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism
  3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organizations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean
  4. Do not let someone making an "incentive" bonus manage a nuclear plant or your financial risks. Odds are he would cut every corner on safety to show profits while claiming to be conservative. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards
  5. Counter-balance complexity with simplicity. Complexity from globalization and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.
  6. Do not give children sticks of dynamite, even if they come with a warning. Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them hedging products, and from gullible regulators who listen to economic theorists
  7. Only Ponzi schemes should depend on confidence. Governments should never need to "restore confidence". Cascading rumors are a product of complex systems. Governments cannot stop the rumors. Simply, we need to be in a position to shrug off rumors, be robust in the face of them
  8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab
  9. Citizens should not depend on financial assets or fallible "expert" advice for their retirement. Economic life should be de-financialised. We should learn not to use markets as storehouses of value: they do not harbor the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control)
  10. Make an omelet with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself.

You can read more about Nassim Nicholas Taleb here.


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