The Black Swan

These days when I check the traffic to this blog, I found there is a noticeable number of readers who are interested in the Theory of Reflexivity by George Soros. In fact, if you google the keywords "George Soros and The Theory of Reflexivity", bhc investment ranked 5th among the returned hits.

My post at the time was not adding anything new to what's already available about The Theory of Reflexivity in the public domain, but simply putting them together after some personal research into the subject. Soros later came out with a book about his theory and his views on the new paradigm in financial markets following the 2008 financial crisis.

I haven't read the book yet. Part of the reasons being that I already knew The Theory of Reflexivity before the crisis hit. Another being that Soros was voting for Omaba in the last U.S. presidential election and had been a supporter of BIGGER government and MORE regulations post the greatest financial crisis since the Great Depression -- which had me wondering about his motive. Therefore, I wasn't eager to read what he has to offer in the book.

While I do believe in The Theory of Reflexivity, I was also intrigued by The Black Swan by Nassim Nicholas Taleb. Below is a snippet taken from wikipedia:

Taleb appeared to be vindicated against statisticians in 2008, as he reportedly made a multi-million dollar fortune during the financial crisis of 2007–2008, a crisis which he attributed to the failure of statistical methods in finance. Universa, where Taleb is adviser, made returns of 65% to 115% in October 2008 in its approximately $2 billion “Black Swan Protection Protocol.”

Taleb's financial success coupled with his earlier predictions have seen him catapulted to prominence. He has appeared on numerous magazine covers and television shows to discuss his views. Taleb started being treated as a "rock star" in Davos 2009 in which he had harsh words for bankers.

In an article in The Times, Bryan Appleyard described Taleb as "now the hottest thinker in the world". The Nobel Laureate Daniel Kahneman proposed the inclusion of Taleb's name among the world's top intellectuals, citing "Taleb has changed the way many people think about uncertainty, particularly in the financial markets. His book, The Black Swan, is an original and audacious analysis of the ways in which humans try to make sense of unexpected events."

Approach to models linked to Austrian School

In his criticism of models, Taleb has taken a point of view in line with the Austrian School of economic thought. He opposes top-down knowledge as an academic illusion and believes that price formation obeys an organic process. His paper with Espen Gaarder Haug asserts that option pricing is determined in a "heuristic way" by operators, not by a model, and that models are "lecturing birds on how to fly", except that in the case of options, the birds might listen. In the book "Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?" Wiley Publishing (2009), Pablo Triana explores this topic with references to Haug and Taleb and critiques of the Black-Scholes-Merton model.

I bought the book and had been reading it on and off over the last few evenings when I can find the time. It was thought-provoking indeed! Allow me to share with you part of the prologue

Before the discovery of Australia, poeple in the Old world were convinced that all swans were white, an unassailable belief as it seem completely confirmed by empirical evidence. The sighting of the first black swan might have been an interesting surprise for a few ornithologists (and others extremely concerned with the coloring of birds), but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single (and, I am told, quite ugly) black bird.

...

I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives. ...

...

The central idea of this book concerns our blindness with respect to randomness, particularly the large deviations: Why do we, scientists or nonscientists, hotshots or regular Joes, tend to see the pennies instead of the dollars? Why do we keep focusing on the minutiae, not the possible significant large events, in spite of the obvious evidence of their huge influence? And, if you follow my argument, why does reading the newspaper actually decrease your knowledge of the world?

It is easy to see that life is the cumulative effect of a handful of significant shocks. It is not so hard to identify the role of Black Swans, from your armchair (or bar stool). Go through the following exercise. Look into your own existence. Count the significant events, the technological changes, and the inventions that have taken place in our environment since you were born and compare them to what was expected before their advent. How many of them came on schedule? Look into your own personal life, to your choice of profession, say, or meeting your mate, your exile from your country of origin, the betrayals you faced, your sudden enrichment or impoverishment. How often did these things occur according to plan?

...

The book reminds me of a recent phenomenon -- Susan Boyle, a way too ordinary looking woman from Blackburn, Scotland. She rose to fame after taking part in Britain's Got Talent and had been making news headlines worldwide. The clip of her on YouTube is about to hit 80 million views! Her debut album was out days ago and is already set to be the best selling album in the current decade. A truly Black Swan phenomenon!