In a fowl mood: the argument for Black Swans over predictability

Citation

Millett, S.M. (2010), "In a fowl mood: the argument for Black Swans over predictability", Strategy & Leadership, Vol. 38 No. 5. https://doi.org/10.1108/sl.2010.26138eae.001

In a fowl mood: the argument for Black Swans over predictability

Article Type: The strategist’s bookshelf From: Strategy & Leadership, Volume 38, Issue 5

The Black Swan,Second EditionNassim Nicholas Taleb,Random House Trade Paperbacks,New York,2010,445 pages

To prepare for the future, senior executives in for-profit companies, institutions, non-profits, and government analyze trends in order to anticipate changes in their external environments. Their goal is to continuously align their organizations’ initiatives with evolving conditions. But the future often surprises managers with discontinuities – the so-called Black Swan events that cannot be predicted from historical trends. Nassim Nicholas Taleb, the author of The Black Swan, a bestselling business book first published in 2007, argues that the future is more random than it is predictable. In that edition, Taleb railed against the smug forecasters – academic economists (especially Nobel Prize winners), Gaussian statisticians, investment bankers, and overly enthusiastic investment advisors – who misled investors. Still incensed, the new second edition released in 2010 is now angry about the Wall Street meltdown and government bailout.

Taleb espouses an epistemology of randomness and a logic of the unexpected, the so-called Black Swans of the title. He believes that the turning points in the history of the financial world occurred according to chance rather than planning and that Black Swans, the very low probability but very high pay off moments, cause randomness to trump probabilities. Taleb asserts that many financial forecasts, based on time series data, trend projections, and standard deviation probabilities, are not only consistently wrong, they are often harmful because they deceive others by hiding the risks of randomness and of unknown future disruptions in seemingly serene markets.

Taleb’s commentary has to be taken in the context of his own experiences as a hedge fund manager and trader in dreaded derivatives, and I will defer to his expertise that in those situations anything can and probably will happen. In his own world, his philosophy makes a lot of sense. Taken out of this context, however, a business manager reader might jump to the conclusion that no strategic planning is valid as the future is all random. Taleb and I part company at this juncture. As a consulting futurist who has worked for corporations around the world, I see both the past and the future as combinations of continuity and change. In my experience, Taleb rightfully argues for the role of sudden and dramatic change, but he underestimates the power of long-term trends as a basis for strategic planning.

I found several new insights in the second edition of the book that reflect the evolution of Taleb’s thinking. For example, he now concludes that forecasting tools may not be absolutely wrong, but rather are routinely applied in inappropriate situations. In his first edition, Taleb was extremely critical of statistical forecasting methods; in the second edition, he softens his tone somewhat by admitting that some methods and tools will provide reasonably accurate projections under specified conditions – just not in the zone of high uncertainty and complex payoffs (or what he calls the Fourth Quadrant). You can’t predict Black Swan events, and attempting to do so borders on intellectual dishonesty, so Taleb argues.

I agree with Taleb to the extent that absolute predictions of events in the future are futile, as too many gaps in current information and imagination exist. We can anticipate the future only to the extent that we understand trend momentum and cause-and-effect relationships, and then we fill in the gaps with inferences based on closed systems or fix sets. Trend extrapolations from the past will work under specified conditions, but trends can by their nature capture only continuities; they cannot predict discontinuities. I also agree with the author that there has been much too much reliance on statistical forecasts loaded with hidden and often very biased assumptions. As the Scottish philosopher David Hume pointed out in the 18th century, just because things seem today the same as they were in the past does not mean that they will automatically be the same in the future.

I also disagree with Taleb when he dismisses trends as irrelevant. He is correct to warn us about the dangers of discontinuities, but he fails to appreciate the long-term strength of trends. Trends are patterns in repeated human behavior. They are based on the rules of institutions and organizations, laws and regulations, culture, tradition, conventions, rituals, and habits. To admit such is no commitment to an unchanging future – there are always small deviations and occasional major disruptions (Black Swans).

Statistical and economic models will be usefully accurate when they deal with variables that are well known, with relationships among variables that are also well known, with stable conditions, and with relatively short time horizons. They will fail miserably, as Taleb correctly asserts, when we do not know all the variables in play, we do not understand well the relationships among them, when conditions are not stable (certainly under conditions of an open system), and the time horizon is relatively long (allowing more time for changes to occur).

As a professional futurist and management consultant, I have learned that forecasts range in prescience according to the proper application of several methods and tools used in combination rather than the reliance upon only one method, one model, and one prediction of the future. Apparently Taleb is not familiar with the evolution of scenario analysis as a method to anticipate several alternative futures in qualitative descriptions as opposed to a single number. He does not discuss scenarios at all in the first edition and rudely characterizes them as one of the “suckers’ methods” in the second edition (p. 372). Scenarios have proven to be very imaginative, to the point of recognizing potential Black Swans, beyond the confines of past trends.

Another new idea articulated in Taleb’s second edition, is that whether or not an event qualifies as a Black Swan all depends upon one’s perspective. One person’s Black Swan may be another person’s initiative. The terrorist attacks upon the US on September 11, 2001, were a Black Swan event to those of us who felt its impacts directly or indirectly. It was not a Black Swan to the terrorists who planned and conducted the attacks. Likewise, those of us who knew little or nothing about real estate speculations and sub-prime mortgage derivatives could not anticipate the financial meltdown of 2007-2008. The very global extent and the severity of the Great Recession surprised most people, except those inside traders who knew what was going on in derivative markets. Those who follow many trends are more likely to catch the early signs of a Black Swan than those who mind only their own business in a narrow-sighted way.

Practical advice for managers

In both editions, Taleb advises investors to follow the “barbell strategy,” which consists of two types of investments: those that are very safe and those that are very speculative. The real risks lay with the middle ground, he warns. On the one hand, safe investments run low risks of loss but pay rather low returns. They are not completely but mostly immune from Black Swans. On the other hand, you should invest in many relatively low costing but potentially high pay-off speculations. Taleb himself has allegedly made a fortune with many small but high reward investments in hedge funds and derivatives.

At the conclusion of the second edition, Taleb prescribes “the ten principles for a black-swan-robust society” several of which are summarized here:

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  Too often the enterprises that become too big to fail are the ones with the most hidden risk.

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  Don’t rely on the same experts and consultants who got us into the global financial crisis of 2008 to get us out of it. Look for fresh, new talent.

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  People who receive large incentives will generally take big risks with critical assets. They should also be punished when they fail as well as rewarded when they succeed.

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  No matter how complex financial enterprises might be, their products should be as simple as possible. Hidden risks will produce excessive debts that undermine stability.

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  Investors need to be protected from themselves by having some types of high-risk investments made illegal.

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  The current debt crisis is a structural problem, not just a temporary one, and so we need to change existing financial structures.

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  We need to move on to more robust economic systems in the 21st century, including letting go of failed institutions, faulty experts and their bad advice, and teaching investors what real risks exist in financial markets.

Stephen M. MillettPresident of Futuring Associates LLC, located in Columbus, Ohio (smillett@futuringassociates.com). He is a Contributing Editor of Strategy & Leadership.