Black Swan Event
Is an event that is impossible to predict
A black swan event is an event that is impossible to predict. It can be called an unlikely unlikelihood, where no one is aware of the possibility of the event, and the possibility itself is extremely unlikely.
This is commonly applied to finance, where freak events such as the stock market and financial system crash lead to a widespread impact on society.
Why is it called that?
Nassim Nicholas Taleb popularized this term following the financial crash of 2008. The story behind using black swans comes from their supposed rarity.
Allegedly, people did not believe in the existence of black swans.
Dutch explorers discovered Black swans in Australia during the 17th century, becoming the first Europeans ever to see them. Hence, they represent the unknown, which are events or occurrences that cannot be ignored just because they have not been observed yet.
Taleb discussed these events in his books 'Fooled By Randomness' and 'The Black Swan: The Impact of the Highly Improbable'. According to Taleb, there are three distinct features of black swan events:
- The event is unpredictable.
- The event has a widespread impact.
- The event is rationalized by hindsight. This means people start claiming they could have expected this to happen (hindsight bias)
Black swans are not unpredictable because they are random. They are unpredictable because they lie outside our current scope of reasoning. This is why the term 'black swan' is used - these swans existed outside what we thought was possible. Taleb teaches us three main lessons in his book:
- Black swans impact most of whom have not prepared for the event
- Do not use the past as a predictor of the future
- Do not treat real-life probabilities in the same way as game probabilities
People who do not see the possibility of the black swan are most adversely affected by its occurrence.
The large-scale and unprecedented events, like the financial market crash of 2008, would have had a much lesser surprise and impact had we known it was coming. The way we acted would have been different. It is the reason why the event is often rationalized by hindsight.
However, Taleb also advises us against using past patterns to predict the future. We favor patterns of the past as if they are concrete and unchanged. They are poor indicators of the surprising black swan events. If the event had occurred in the past, it is unlikely to be treated as such.
Although the markets continuously went up until 2007, this would have been a poor predictor of the 2008 crash.
Finally, Taleb also coined the term 'ludic fallacy.' The fallacy is related to basing our decisions on probability as if we were playing a game like roulette. Instead, he argues that we could apply statistics in controlled environments where results are visible and defined.
However, this does not apply to the vast number of circumstances and surprises awaiting the real world. Oversimplification, in this case, is worse.
Many large-scale financial crashes can be categorized as black swan events. Examples of some major financial accidents over the past are:
- The stock market crash and recession of 1929
- The Asian financial crisis of 1997
- The financial crisis of 2008
- The 2000-2001 dot com bubble
A multitude of factors can explain almost all financial crises. For example, the stock market crash in 1929 led to a decrease in investor confidence. This, in turn, led to decreased spending and consumption.
Or in 2008, commercial banks failed due to overly risky mortgage-backed securities following the burst of the housing market bubble.
Such events can be explained retrospectively, but at the time, they were extremely unpredictable and impossible to predict on the societal level.
Some non-financial examples of such events that are commonly referred to include:
Again, these can be explained due to numerous factors. However, they would likely not have been predicted to occur by many at the time.
Positive black swan events can also occur. Many of the previous examples - including financial and social crises - are negative events. The upside potential is exceptionally high for positive events, while the downside is capped.
This is converse to negative black swan events. Instead, areas filled with high unpredictability often lead to more positive outcomes.
Taleb highlights several industry areas as having high potential for positive black swans. These include movies, publishing, scientific research, and venture capital (VC). He argues that books, for example, have easily controllable downsides while the upsides can make the book popular for any number of reasons.
To increase the opportunity of encountering potential positive black swan events, one must expose themselves to these industries. Keeping one's mind open to potential opportunities and seizing potential opportunities is also crucial.
Therefore, going to dinner parties, first dates, or publishing books are good positive opportunities. The upside far outweighs the downside in many of these cases. The price of publishing a book is small, while the opportunity if the book blows up is extremely good.
Other types of Events: Grey Swan vs. White Swan Events
Grey swan events differ from black swans in a few key areas. Primarily, the event is known as a possibility. However, this probability is seen as extremely small. The difference, therefore, is that the outcome is known and predictable.
There is still the similarity that a grey swan event has the potential to have a significant and widespread impact. For example, natural disasters are predictable outcomes with a small perceived percentage of occurring.
Multiple choice outcomes, such as the Brexit election of 2016 and Donald Trump's election, can be seen as grey swan outcomes. This is because the possibility of those outcomes was available, not heavily favored. Grey swans can be both positive and negative.
Another negative grey swan example is arguably the COVID-19 pandemic. Although the current pandemic was highly unlikely, similar pandemics have occurred in the past. The distinction between the two can sometimes be argued.
As grey swans have somewhat predictable outcomes, the management of grey swans differs. Taleb says that the impacts of negative grey swans, in particular, can be minimized by good risk management. He proposes a term known as 'anti-fragility' to make our capacities more than simply robust.
Anti-fragile structures can benefit from adverse shocks rather than just surviving them. For example, maintaining low debt or avoiding it altogether is essential in anti-fragility.
A white swan event is a predictable event. Some argue that even COVID-19 was a white swan event due to the frequency and nature of pandemics. The impact of the event can also be easily estimated.
For example, there are 500m COVID-19 cases with early 7m deaths and a widespread economic impact that cannot be negated. The common feature between black, grey, and white swan events is that they have a large-scale impact on society.
After the fact, white swan events are usually pinpointed to human error. A more pinpoint explanation of why and how certain mistakes led to the event exists. The same can be said for grey swan events.
However, this does not mean we can ignore the factors leading to white or grey swan events. Both events can have devastating widespread impacts. Regardless of whether the pandemic was a white or grey swan event, it unarguably has shaped much of the modern-day.
The factors were leading to grey and white swan events, although more predictable, maybe no less fixable than black swan events. The interactions of people inevitably lead to unpredictable outcomes. Here, Taleb argues that anti-fragility is most important.
What is anti-fragility?
Taleb coins the term anti-fragility to try and describe a system that goes beyond simple robustness. He describes it as the following:
"Anti-fragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the anti-fragile gets better."
He saw robustness or resilience as not perfectly antithetical to fragility. Therefore, he developed a new term that counters fragility more directly. Anti-fragile systems can grow and thrive due to stressors and mistakes rather than just withstanding them.
Robust systems are shocked and remain the same, even if they can withstand the pressure. Therefore, anti-fragility can be widely applied to a range of fields.
To become anti-fragile is not the same as optimization. While we should look to reduce redundancies in business, becoming more effective is not the same as becoming effective at dealing with fragility and unexpected shocks. In a world of black swans, optimization is not a possibility.
Anti-fragility has many elements. For one, it is not to be over-reliant on any single asset or income stream. One must not rely on a single product or strategy.
Rather, maintaining a diversity of income, shareholders, and consumers is essential to keep anti-fragility. This can help minimize debt, which Taleb sees as crucial in not having a fragile business.
Decreasing the reliance on single factors can also help reduce bottlenecks and chokepoints. This is particularly important in the case of supply chains, which are particularly vulnerable to unexpected catastrophes.
By relying on multiple suppliers rather than single ones, supply chain anti-fragility is achieved. A barbell strategy is what Taleb proposes to try and increase our resilience agains these events. In business, this would mean dividing investments between riskier and safe investments.
This helps increase the number of revenue streams while limiting potential downsides. It is a barbell strategy as little focus is given to the middle, only to the extremes.
How can you manage a black swan event?
The feature of these events is that they are distinctly unknown, and therefore people have a difficult time making the correct decisions and adjustments during the shock. Often, a new correct decision must be created in the emergency response rather than finding a previously used decision.
a) Assume a black swan response team
Have a specialist team filled with interdisciplinary and inter-department members to best navigate a difficult event. In addition, having a team of directly experienced consultants with freak event-related decision-making can provide an invaluable customized approach.
b) Improve risk agility
In the case of these events, senior management must be able to react quickly. Therefore, large amounts of useful and accurate data are important to be handed over to the management. There is also a need to make the information easily digestible.
c) Optimize communications
In times of difficulty, the perception of a firm can look poor and tank its stock. It is essential to maintain reasonable consumer confidence during these events. The firm must use visualization tools and story-telling business intelligence to transmit information effectively.
d) Pursue R&D
R&D is essential when trying to develop a solid solution for difficult situations. The team may be able to conjure solutions to freak events that may have been overlooked or did not previously exist. Rather than efficiency, it is about making new solutions from scratch.
What are the implications of black swan events?
One key implication is that complex models relying on mathematical probabilities may be pointless. This is because normal distribution and other standard probabilistic measures do not necessarily apply to these events, as they rely on several assumptions that do not hold.
Many statistics rely on the probabilities of past events. However, these are freak events that do not rely on past events or their probabilities. Therefore, doing so may even be more dangerous.
People are also naturally, therefore, blind to surprising events. Psychologically, people are prone to developing 'collective blindness' towards black swan events. This means that rather than adapt features of their behavior to deal with black swans, we allow them to occur.
Another psychological feature that occurs is hindsight bias. This stems from one of the features of black swan events, which means people believe that the event could have been rationally predicted and explained.
People are unrealistic about their expectations of predicting another major event based on the previous major event and are, therefore, unable to deal with another different black swan.
Ultimately, by their very nature, black swans are impossible to predict. Therefore, we cannot use mathematical models or experiences of previous events to prepare for another incident. Instead, we must build up our anti-fragility to deal with unexpected situations.