The Black Swan: The Impact of the Highly Improbable

Indeed, we have psychological and intellectual difficulties with trial and error, and with accepting that series of small failures are necessary in life. My colleague Mark Spitznagel understood that we humans have a mental hang-up about failures: “You need to love to lose” was his motto. In fact, the reason I felt immediately at home in America is precisely because American culture encourages the process of failure, unlike the cultures of Europe and Asia where failure is met with stigma and embarrassment. America’s specialty is to take these small risks for the rest of the world, which explains this country’s disproportionate share in innovations. Once established, an idea or a product is later “perfected” over there.

Volatility and Risk of Black Swan

People are often ashamed of losses, so they engage in strategies that produce very little volatility but contain the risk of a large loss—like collecting nickels in front of steamrollers. In Japanese culture, which is ill-adapted to randomness and badly equipped to understand that bad performance can come from bad luck, losses can severely tarnish someone’s reputation. People hate volatility, thus engage in strategies exposed to blowups, leading to occasional suicides after a big loss.

Furthermore, this trade-off between volatility and risk can show up in careers that give the appearance of being stable, like jobs at IBM until the 1990s. When laid off, the employee faces a total void: he is no longer fit for anything else. The same holds for those in protected industries. On the other hand, consultants can have volatile earnings as their clients’ earnings go up and down, but face a lower risk of starvation, since their skills match demand—fluctuat nec mergitur (fluctuates but doesn’t sink). Likewise, dictatorships that do not appear volatile, like, say, Syria or Saudi Arabia, face a larger risk of chaos than, say, Italy, as the latter has been in a state of continual political turmoil since the second war. I learned about this problem from the finance industry, in which we see “conservative” bankers sitting on a pile of dynamite but fooling themselves because their operations seem dull and lacking in volatility.

Barbell Strategy

I am trying here to generalize to real life the notion of the “barbell” strategy I used as a trader, which is as follows. If you know that you are vulnerable to prediction errors, and if you accept that most “risk measures” are flawed, because of the Black Swan, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative. Instead of putting your money in “medium risk” investments (how do you know it is medium risk? by listening to tenure-seeking “experts”?), you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury bills—as safe a class of instruments as you can manage to find on this planet. The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options), preferably venture capital-style portfolios.[43] That way you do not depend on errors of risk management; no Black Swan can hurt you at all, beyond your “floor,” the nest egg that you have in maximally safe investments. Or, equivalently, you can have a speculative portfolio and insure it (if possible) against losses of more than, say, 15 percent. You are “clipping” your incomputable risk, the one that is harmful to you. Instead of having medium risk, you have high risk on one side and no risk on the other. The average will be medium risk but constitutes a positive exposure to the Black Swan. More technically, this can be called a “convex” combination. Let us see how this can be implemented in all aspects of life.

“Nobody Knows Anything”

The legendary screenwriter William Goldman was said to have shouted “Nobody knows anything!” in relation to the prediction of movie sales. Now, the reader may wonder how someone as successful as Goldman can figure out what to do without making predictions. The answer stands perceived business logic on its head. He knew that he could not predict individual events, but he was well aware that the unpredictable, namely a movie turning into a blockbuster, would benefit him immensely.

So the second lesson is more aggressive: you can actually take advantage of the problem of prediction and epistemic arrogance! As a matter of fact, I suspect that the most successful businesses are precisely those that know how to work around inherent unpredictability and even exploit it.

Recall my discussion of the biotech company whose managers understood that the essence of research is in the unknown unknowns. Also, notice how they seized on the “corners,” those free lottery tickets in the world.

Here are the (modest) tricks. But note that the more modest they are, the more effective they will be.