Нассим Талеб - The Black Swan. The Impact of the Highly Improbable

Also, for example, one can buy insurance, or construct it, to robustify a portfolio.

Overspecialization also is not a great idea. Consider what can happen to you if your job disappears completely. Someone who is a Wall Street analyst (of the forecasting kind) moonlighting as a belly dancer will do a lot better in a financial crisis than someone who is just an analyst.

3. Avoid prediction of small-probability payoffs—though not necessarily of ordinary ones .

Obviously, payoffs from remote events are more difficult to predict.

4. Beware the “atypicality” of remote events .

There are suckers’ methods called “scenario analysis” and “stress testing”—usually based on the past (or on some “make sense” theory). Yet (I showed earlier how) past shortfalls do not predict subsequent shortfalls, so we do not know what exactly to stress-test for. Likewise, “prediction markets” do not function here, since bets do not protect an open-ended exposure. They might work for a binary election, but not in the Fourth Quadrant.

5. Beware moral hazard with bonus payments .

It’s optimal to make a series of bonuses by betting on hidden risks in the Fourth Quadrant, then blow up and write a thank-you letter. This is called the moral hazard argument. Bankers are always rich because of this bonus mismatch. In fact, society ends up paying for it. The same applies to company executives.

6. Avoid some risk metrics .

Conventional metrics, based on Mediocristan, adjusted for large deviations, don’t work. This is where suckers fall in the trap—one far more extensive than just assuming something other than the Gaussian bell curve. Words like “standard deviation” are not stable and do not measure anything in the Fourth Quadrant. Neither do “linear regression” (the errors are in the Fourth Quadrant), “Sharpe ratio,” Markowitz optimal portfolio, ANOVA shmanova, Least square, and literally anything mechanistically pulled out of a statistics textbook. My problem has been that people can accept the role of rare events, agree with me, and still use these metrics, which leads me to wonder if this is a psychological disorder.

7. Positive or negative Black Swan?

Clearly the Fourth Quadrant can present positive or negative exposures to the Black Swan; if the exposure is negative, the true mean is more likely to be underestimated by measurement of past realizations, and the total potential is likewise poorly gauged.

Life expectancy of humans is not as long as we suspect (under globalization) because the data are missing something central: the big epidemic (which far outweighs the gains from cures). The same, as we saw, with the return on risky investments.

On the other hand, research ventures show a less rosy past history. A biotech company (usually) faces positive uncertainty, while a bank faces almost exclusively negative shocks.

Model errors benefit those exposed to positive Black Swans. In my new research, I call that being “concave” or “convex” to model error.

8. Do not confuse absence of volatility with absence of risk .

Conventional metrics using volatility as an indicator of stability fool us, because the evolution into Extremistan is marked by a lowering of volatility—and a greater risk of big jumps. This has fooled a chairman of the Federal Reserve called Ben Bernanke—as well as the entire banking system. It will fool again.

9. Beware presentations of risk numbers .

I presented earlier the results showing how risk perception is subjected to framing issues that are acute in the Fourth Quadrant. They are much more benign elsewhere.

* Most of the smear campaign I mentioned earlier revolves around misrepresentation of the insurance-style properties and performance of the hedging strategies for the barbell and “portfolio robustification” associated with Black Swan ideas, a misrepresentation perhaps made credible by the fact that when one observes returns on a short-term basis, one sees nothing relevant except shallow frequent variations (mainly losses). People just forget to cumulate properly and remember frequency rather than total. The real returns, according to the press, were around 60 percent in 2000 and more than 100 percent in 2008, with relatively shallow losses and profits otherwise, so it would be child’s play to infer that returns would be in the triple digits over the past decade (all you need is one good jump). The Standard and Poor’s 500 was down 23 percent over the same ten-year period.

VIII

THE TEN PRINCIPLES FOR A BLACK-SWAN-ROBUST SOCIETY *

I wrote the following “ten principles” mostly for economic life to cope with the Fourth Quadrant, in the aftermath of the crisis.

1. What is fragile should break early, while it’s still small .

Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks 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 bailout should be free, small, and risk-bearing. We got ourselves into the worst of capitalism and socialism. In France, in the 1980s, the socialists took over the banks. In the United States in the 2000s, the banks took over the government. This is surreal.

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 in 2008. It is irresponsible and foolish to put our trust in their ability to get us out of this mess. It is also irresponsible to listen to advice from the “risk experts” and business school academia still promoting their measurements, which failed us (such as Value-at-Risk). Find the smart people whose hands are clean.

4. Don’t 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” from these savings while claiming to be “conservative.” Bonuses don’t accommodate the hidden risks of blowups. 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. Compensate 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. It’s the leverage of efficiency. Adding debt to that system produces wild and dangerous gyrations and provides no room for error. Complex systems survive thanks to slack and redundancy, not debt and optimization. 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 dynamite sticks, even if they come with a warning label .

Complex financial products need to be banned because nobody understands them, and few are rational enough to know it. We need to protect citizens 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.”