BIG IDEAS #3: BLACK SWAN THEORY (PART 2/2)

flickr photo by n.bhupinder http://flickr.com/photos/125207874@N04/14556052521 shared under a Creative Commons (BY) license

flickr photo by n.bhupinder http://flickr.com/photos/125207874@N04/14556052521 shared under a Creative Commons (BY) license

So how did Taleb do it? How did he make what he so eloquently likes to call “F*** you money” on account of what it allows you to say to people you no longer have to work for?

Well, when many people were continuing to pour their money into sub-prime mortgages, Taleb was betting that the market would collapse.

So how could he predict what other people could not? What pattern allowed him to tell the future? What special formula, magic spell or access to a time-travelling Delorean did he have?

None of the above.

What Taleb knew was that systems that are blind to their own weaknesses will eventually break down. Though I’m grossly oversimplifying, what he basically did was to bet a small amount on a regular basis that a black swan event (a big market crash) will happen eventually. He did the same thing in 1986 and 2000. Every time there was a big financial downturn the statistical models used by most other traders would tell them that what had gone up in the past would carry on growing in the future (a basic induction error).

DEALING WITH UNCERTAINTY

The trick is not to predict the future, it is to do your best to insure yourself against it.

Human beings are emotionally and instinctively wired, first and foremost, for survival. While we may be hopeless at predicting the future, we are generally very good at playing safe; at hedging our bets. And these protective instincts allow us to be wrong, day after day, year after year, without making life-ending decisions!

But black swan theory is not just a cautionary tale about overexposure in stock markets, it is a strategy for life. Instead of trying to control what happens, we need to experiment; to speculate. We just need to make sure that our experimenting is done with a safety net.

UPSIDE DOWNSIDE

Dealing with uncertainty is all about managing risk. To do the complex mathematics, data work and explanation justice you’d have to read his books, but the summary is that in real life Taleb advises that nature tends to be unfair and unequal. That means that in volatile environments you usually know what is more likely to happen but when something unexpected occurs it tends to be disproportionately extreme.

A good example of the opposite by the way is the lottery; it seems like a potentially huge reward for a small risk yet in reality the environment is completely artificial and predictable so you’re just as likely to lose your pound every time you play.

flickr photo by ClawzCTR http://flickr.com/photos/clawzctr/7015616829 shared under a Creative Commons (BY-ND) license

flickr photo by ClawzCTR http://flickr.com/photos/clawzctr/7015616829 shared under a Creative Commons (BY-ND) license

In a given season, a top football team like Chelsea will probably win most of their matches. But when they lose a game, they’ll often lose another swiftly after. If you set off late by 5 minutes in a busy city, the chances are you’ll be late by more than 5 minutes. It’s the mathematical equivalent of sod’s law: as the classic saying goes, you wait for ages and then three buses come along at once.

The worst possible risk-taking involves betting on something (let’s say backing out of your drive on to a busy road when you can’t see properly) with an unpredictable potentially huge downside (you might die) and a small but predictable upside (you get to work two minutes earlier).

The best possible risk-taking involves betting on something (let’s say promising to meet friends for a quick drink but having an excuse to leave early) with a small predictable downside (the price of a pint and less than an hour’s small talk) and an unpredictable potentially huge upside (you enjoy yourself and end up staying and having the best night of your life).

There are a bucket load of applications of black swan theory for the choices that we all make on a daily basis. Here are a few examples that I personally use, and that you may already use yourself without even thinking:

  • Packing a light coat in case it rains on holiday
  • Leaving a longer period of time than you need in case of traffic when setting off on a car journey
  • Promising yourself a reward afterwards regardless of how a job interview goes
  • Leaving your bank card at home on a night out and only taking as much cash as you’ll be happy to have spent when you’ve sobered up in the morning

Having a robust risk-strategy for life’s decisions is really all about being happy with the worst case scenario. If you can create an attitude and a way of living that acts to insulate you against at least some of life’s uncertainties then the best part is that you can afford to make more mistakes. In other words: freedom and the confidence to live your life the way you want to.

When you can look at life in this way, uncertainty is no longer about fear, it’s about fun and excitement. And in a world that seems so uncertain the more you can take smart risks the more you expose yourself to positive black swans.

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5 comments

  1. Pingback: BIG IDEAS #3: BLACK SWAN THEORY (PART 1/2) | PeteBur.nett
  2. Tom · July 30, 2015

    I do not use any of your examples on a day to day basis, do you have some that would be relevant to me?

    Like

    • peteburnett · July 30, 2015

      Basically, anything where your downside risk is small and predictable and the upside is potentially huge. Reading highly recommended books would be a good example. A habit of reading and committing to 10 minutes on your phone in a morning (or whilst on the toilet after lunch) is a small price to pay for potentially being inspired or enlightened with the finest thoughts that humanity has to offer.

      Like

  3. Sabiscuit · October 25, 2015

    Is there a book form of this blog? I need to peel through the pages. Fascinating thought tour, mate. And thanks for the fries and ketchup in the other post. x

    Liked by 1 person

    • peteburnett · October 25, 2015

      Thanks for reading! As yet, this is just an experiment I’ve been trying at the weekend. Many of the ideas form the basis of a novel I’m writing (which may take a while to complete). Anyway, I’m glad you’ve enjoyed some of the blog.

      Liked by 1 person

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