Markets and Birds of a Different Feather (1)

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Dr. Nassim Nicholas Taleb has been described as "part literary essayist, part empiricist and part no-nonsense mathematical trader."  He received his MBA from Wharton and his PhD from the University of Paris.  He was a successful derivatives trader on Wall Street, but his real talent is as a writer.  He is most famous for his books, Fooled By Randomness, The Hidden Role of Chance in Life and in the Markets, published in 2004, and The Black Swan, The Impact of the Highly Improbable, published in 2007.  Both books, which take on conventional financial theory, are best sellers.

In his Prologue to Fooled By Randomness, Dr. Taleb, a self described Levantine (born in Lebanon), explains that his book is about luck, which is mistakenly perceived by those lucky souls as evidence of their personal skills, and about randomness  which is mistakenly seen as a surprising event which might have been, but was not, anticipated.  Something unusual (good or bad) happens in the market, shocking everyone, and market professionals immediately reach for explanations.  The response "We don't know why." is an unacceptable answer in the public media.  That would make for a fairly short television broadcast or newspaper story with a concomitant loss of advertising dollars.

Taleb criticizes economists, journalists, financial television analysts and others for refusing to acknowledge that the one-in-ten billion (or higher) possibility really can happen.  Their statistical analyses and Gaussian distribution (bell curve) charts do not take such extremely rare probabilities into account.  Although armed with reams of data based on computer analysis of vast numbers of probabilities, they do not know that they do not know.  Or, viewed more cynically, if they do know that they don't know, they won't admit it.

All swans were thought to be white until in 1697 the Dutch explorer, Willem de Vlamingh, discovered a black one in Australia.  One ugly bird destroyed a belief previously held by everyone in the ornithological world at that time.  Dr. Taleb uses the term Black Swan to identify an event with three characteristics.  First, the event is an outlier, which means that it is beyond the expectations of most, if not all, people.  It will not be revealed in a standard bell curve distribution. Second, it will have a significant effect or impact (think September 11, 2001 or the market crash of October, 1987).  Finally, it is an event in the wake of which people immediately demand an explanation.  The phrase "Sh_t Happens." is not an acceptable answer to "How could this happen?" for most on Wall Street.

One of the premises of the Black Swan is that events of this type actually happen with greater frequency than previously imagined.  It might be that, as a species, we humans need to perceive that we have order in and control over our lives.  Black Swans serve to remind us that we are not in total control, a terrifying thought for many.  The implications of this for the stock market are significant.  Taleb provides two rates of return in a single graph.  One line shows the return in the US stock market over the past fifty years.  The second one charts the return without the ten most volatile days (up or down) over that same fifty year period.  The reduction in return without those ten days is dramatic.  Individual investors should bear this in mind when formulating their investment strategies.

We will continue our look at Dr. Taleb's ideas in the next blog.

Comments are always welcome.