Nassim Nicholas Taleb - The Black Swan

Nassim Nicholas Taleb was born in 1960, in Lebanon. Fifteen years later, in 1975, a civil war broke out in the country. The student Nassim Nicholas Taleb participated in a student riot to protest against the war, but he was captured and jailed. "I was put in jail for (allegedly) attacking a policeman with a slab of concrete," he said.
    During the war, he spent a lot of the time in a basement to avoid the flying bullets. The school was closed, and Nassim Nicholas Taleb got bored. He wanted to be a philosopher so he began reading different books from authors such as Hegel and Marx.
    He later left Lebanon and attended the University of Paris and the Wharton School of the University of Pennsylvania. In 1983, he finished his Master of Business Administration. After working at different companies as a trader, Nassim Nicholas Taleb fell in love with options.

On his own
As an options trader, Nassim Nicholas Taleb found a job at First Boston. He focused on arbitrage - making money by exploiting tiny pricing anomalies between different markets. He was also convinced that the financial markets systematically underestimated the risk of big improbable events.
    On October 19, 1987, the Dow Jones dropped with 22 percent – a big improbable event. At that Monday, Nassim Nicholas Taleb had a big position in Eurodollar to profit from this event. "97 percent of the money I have ever made was on Black Monday in 1987," he said.
In 1992, Nassim Nicholas Taleb moved to Chicago to become a pit trader at the Chicago Mercantile Exchange. At the same time, he was working on his Ph.D in option pricing at the University of Paris. The Ph.D was completed in 1998.
    In 1999, Nassim Nicholas Taleb founded the hedge fund Empirica. The goal of the company was to offer clients protection against big improbable events, such as the blow-up of the hedge fund LTCM and the stock market crash of Black Monday. The insurance consisted of options. "The goal was to protect investors against market crashes, not to make money," he said. The hedge fund closed in 2004.
    Today, Nassim Nicholas Taleb has stepped back from trading at Wall Street. But he remains as an adviser to the California based hedge fund firm Universa Investments LP. Universa has a Black Swan Protection Protocol – they hedge roughly $1 billion against certain events that can cause market declines. The firm has another $300 million to bet against large positive jumps in individual stocks. The hedge fund want the infrequent huge payouts – they are not interested in the small frequent payouts.

The essence of the strategy Nassim Nicholas Taleb is using when trading is aiming for big profits followed by several small losses. Hopefully will the big profits be larger than the many small losses. But this strategy is unfortunately not always possible. Big events, such as Black Monday, are not common enough. He also had to focus on technical inefficiencies between complicated instruments, and on exploiting these opportunities without being exposed to the rare events.
    Nassim Nicholas Taleb does not believe in forecasting the market. "I was convinced that I was totally incompetent in predicting market prices – but that others were generally incompetent also but did not know it, or did not know that they were taking massive risks," he said.
    He is also ignoring different market indicators. "At 8:30 AM, my screen would flash some economic number released by some institution, for example Non-farm Payrolls," he said. "I never had a clue what these numbers meant and never saw any need to invest energy in finding out."
    One can say that Nassim Nicholas Taleb was a quant in reverse. He studied the models and the limits of the models the quants were using. A quant is someone who applies mathematical models of uncertainty to financial data and complex financial instruments.
    Nassim Nicholas Taleb has since his trading career ended, written two famous books: Fooled by Randomness and The Black Swan (Since I wrote the article, he has also written the book Antifragile). These books have now made him famous enough to charge more than $60,000 for some of his lectures.
    Fooled by randomness. The essence of the book is that it is easy to confuse skills with luck. For example, one can make money in the financial market by being lucky or by having skills. "Skills and hard work are not always enough," he said. "Hard work plus luck is what gets you a jet instead of just a BMW."
    The Black Swan. The black swan bird was found in Australia in the 17th century. Before that everyone thought that all swans were white, but one single observation of a black swan changed that. A Black Swan event has the following three attributes:
  • Unpredictability. Nothing in the past shows that the event is possible. For example: October 19, 1987, when the Dow Jones dropped with 22 percent. The Dow Jones had never dropped with 22 percent in one day before 1987.
  • Consequences. It carries an extreme impact.
  • Retrospective explainability. It is easy to explain why the Dow Jones dropped with 22 percent, but only after it had happened.
A Black Swan Event can be positive or negative. Some traders made money on October 19, 1987 – and some lost money. The trader Paul Tudor Jones was one of the few who made money. So how can we cope with Black Swans? The first step is to find out which one of the following two groups of randomness the sample you have belongs to:
  • Mediocristan. The largest observation will remain impressive, but insignificantly, to the sum. For example: Weight of humans, height of humans.
  • Extremistan. One single observation can make a severe difference to the total. For example: Book sales, wealth. It is here one can find Black Swan events.
It can sometimes be hard to be certain about which group the sample belongs to. One can think it is Mediocristan, but later find out that the same sample belongs to Extremistan. If your sample belongs to Extremistan, the Black Swan could actually be gray. Gray Swans are Black Swans that you can predict – like earthquakes, blockbuster books, stock market crashes – but for which it is not possible to completely figure out the properties and produce precise calculations. For example, you know that you will sell a book you have written, but not how many books. A true Black Swan is impossible to predict. For example, no one could have predicted the spread of computers in the 1960s.
    To profit from Black Swan events, Nassim Nicholas Taleb thinks that one should be hyper-conservative and hyper-aggressive at the same time. Don´t buy medium-risk investments because nobody knows if the investment has a medium-risk. One should put 80-95 percent of the investments in extremely safe instruments, and the remaining in many different extremely speculative bets.

  • Don't try to predict the future with the help of past events in Extremistan. As the trader Salem Abraham said: "The one lesson I was clear on: always know the thing that they say can never happen, can happen."
  • Don´t be fooled by randomness. One can be profitable in the financial market by having skills or just being lucky.
  • One can predict Gray Swans, but it is impossible to predict the exact consequences of a Gray Swan event. It's impossible to predict a Black Swan event