They do exist! Black Swans and the approach to risk

“Honey, I swear—I saw black swans!” Byron was back from his journey exploring the Pacific, and was adamant about what he had seen. But his wife Patricia knew better. “No.  Everyone knows that all swans are white. It’s common knowledge.” Patricia was right because all swans in Europe were white and all empirical evidence supported her beliefs. But it turns out that everyone was wrong. Europeans couldn’t have predicted the discovery of black swans in Australia, but they had to immediately change their beliefs with one simple discovery.

So-called Black Swans - rare, unpredictable events - as described by author Nassim Taleb provide opportunities for massive gains or massive failures. Taleb describes these events as having three primary characteristics:

1)    Black Swans are outliers with low probabilities. These events lie outside the realm of normal expectations. They can’t be readily predicted, even using sophisticated models.

2)    Black Swans have extreme impact. These events change something fundamental about the world – either in terms of economic or social costs. Although the discovery of black swans in Australia might not have had this kind of impact, World War I and September 11th certainly did.

3)    In hindsight, Black Swans are very easy to explain. One example is the recent financial crisis of late 2008. As Taleb explains, today many people claim they saw the crisis coming, but these same individuals also held bank stocks, showing that indeed only hindsight is 20/20.

Black Swans are everywhere. These types of events define our modern history from stock market crashes to terrorist attacks to world wars to banking crises. But Black Swans don’t necessarily have to be negative, they can be positive as well.

Positive Black Swans might include new technologies – such as the Internet, runaway bestsellers or blockbuster drugs. Who knew that a communication protocol used by the military would transform into the World Wide Web and change the way society works? In the same manner, who knew that a potential hypertension medicine would change the love lives of millions of people around the world?

How do Black Swans factor in the business world?

Taleb is critical of many modern management and financial techniques in which companies fool themselves into thinking that they can control or predict their future with great certainty. He argues that it is impossible to predict or control Black Swan events, which are often the greatest source of value creation. Instead, he suggests organizations should try to optimize for:

•    Maximizing the chances for positive Black Swans to occur: Companies accomplish this through taking risks while minimizing the costs associated with those risks. Taleb would argue that companies should take all the “cheap” risk they can because being aggressive will ultimately create economic growth. In gambling terms, he wants to be that hyper-aggressive gambler who understands all of the best bets at the casino, always risking a small amount as long as the payoff is maximized. As Taleb says, “learn to fail cheaply, with pride, comfort, and pleasure – and do it often”.

•    Minimizing the chances for negative Black Swans: Since negative Black Swans can come in many forms such as economic crises, terrorist attacks, or even consumer backlash, it is difficult to be specific on this topic. Taleb would argue that companies should be hyper-conservative on downside risk, shying away from huge bets that have the potential to be very costly.

In short, Taleb thinks most companies have it wrong. In a recent interview, he said “Be hyper-conservative when it comes to downside risk yet hyper-aggressive when it comes to opportunities that cost you very little. Most people have the wrong instinct. They do the opposite.”

Sources:

Webb, Allen. “Taking improbable events seriously: An interview with the author of The Black Swan.” McKinsey Quarterly, December, 2008

Taleb, Nassim. “The Black Swan.” Random House, Inc., New York, 2007.

Gladwell, Malcolm. “Blowing up.” The New Yorker, April 22 & 29, 2002.

Image Source: ianmichaelthomas