flaw in Black Swan theory: few events are "unexpected"

[sniglet]

I've been pondering Nassim Nicholas Taleb's "Black Swan" theory lately, and am wondering if maybe he missed a critical point. Perhaps it's not so much that consequential events result from unforeseen happenings, but rather that momentum prevents people from taking actions until it is too late.

Take the credit bubble as an example. Not only was it predictable that there would be a fall-out from the loose underwriting standards (e.g. giving mortgages to people with poor credit, no income, etc), but we have numerous people on record for having foreseen this credit crunch years ago. Apocalyptic books were written on the subject early in the millennium, and there were even insiders who fought against the trends (the Wall Street Journal has documented how some conservative investment bankers were shown the door because they fought against the growing bets on CDOs and dodgy mortgages).

Aside from the current credit crisis, even the .com crash was predicted years before it occurred, with none other than Alan Greenspan stating that stocks were rising beyond any rational basis (hence the famous "irrational exuberance" speech).

It's perfectly understandable that investment bankers would marginalize anyone who suggested they cut back on mortgage securitization deals that were minting billions of dollars in profits (and padding their bonuses) back in 2005. So what if there might be some storm clouds out on the horizon, if you are making a fortune at something today? No one is going to walk away from the feed trough prematurely, and will instead stay until there is nothing left. Why would a successful software firm completely change its business model (that is currently highly successful), and products, when there might still be many years of gravy still ahead? Who wants to leave all that money on the table?

Ironically, it is often the people who's intuitions are correct who end up suffering the most. Sure, you might be right in predicting some major future event, but bucking the trends (and social pressures) has consequences. As I mentioned earlier, more than a handful of investment bankers lost their jobs in recent years due to their reluctance to "get on board" with the easy credit movement. In the end, many people who followed the trend might still come out ahead. So what if a mortgage broker gets fired today? They were making $400,000 a year a short while ago. It will take someone else making $70,000 many years to equal the same earning capacity.

My point is this: game-changing events are almost always foreseeable, but social forces prevent most organizations from doing anything about it.

The implications are clear. It is unlikely that any business will be undone from some new technology, or trend, emerging from out of the blue. Rather, the disruptive events that occur won't be surprises at all (except to those who willfully closed their eyes), and in retrospect we will find that organizations marginalized, or expunged, those people who "saw" the future and tried to do something about it.

Unfortunately, the trendiness of Messr Taleb's Black Swan theory is almost becoming a convenient excuse for companies who run into trouble. Hey, massively significant unpredictable events happen all the time, so we can't be responsible for getting caught with our pants down. How were we to know that the once in a 500 year flood was going to happen now?

[rose-colored-coolaid]

Interesting argument, sniglet. Even some true black swans, like hurricane Katrina were predicted (the levees were known to be suspect I think). And the tsunamis that followed were not completely unpredicted either (they have those warning sirens for a reason).

I think it's a flaw however to even compare any bubble to a black swan. Essentially every bubble shows signs of popping prior to it's eventual demise. Smart people always announce the disconnect, then it performs one final upward push...and pop.

A real black swan is more like company X invests $$$ in technology Y, only to discover that once their investment is made new technology Z is patented which is half the cost and twice as good. Such an event really is a black swan. But perhaps the point is that something truly unexpected can probably only happen on a micro scale, rather than on a large scale.

[jon]

There is also the matter that a surprise for some people is not for another. Greenspan said he was surprised to find out that sub-prime had grown to 20% of the market. People might hear anecdotal evidence of bad loans, but until someone assembles convincing macro scale data, it won't get traction.

That awareness needs to be compelling enough to affect the public perception of the steps needed. A crackdown on mortgage lending might not have been appreciated. Following 9-11, there was concern about scattered evidence of a general threat was ignored that should have led to stricter airport screening. Now there is better tracking of those threats, along with evidence of various probing of defenses going on in flights, and yet still there is complaining about the steps taken in response.

[sniglet]

[Alan]

How many inventions seem to have the same importance as something like automobiles but don't turn out to have the same effect? I think the "easy predictability" is an illusion caused by survivor bias.

[TJ_98370]

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.....Perhaps it's not so much that consequential events result from unforeseen happenings, but rather that momentum prevents people from taking actions until it is too late.....

Really interesting post sniglet. I would suggest that a distinction of a good manager is that action would be taken before it is too late, despite conventional wisdom.

The first sentence In the Foreword (written by Bernard M. Baruch) of John MacKay's Extraordinary Popular Delusions and the Madness of Crowds is:

All economic movements, by their very nature, are motivated by crowd psychology....

In case you have not heard of it, Extraodinary Delusions was written in 1852 and includes the famous Tulipmania story.
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[sniglet]

[TJ_98370]

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sniglet said -

...There are known cases where conservative investment bankers were shoved out the door to prevent them getting in the way of the bubble....

That may be true, but I bet those conservative investment bankers are not being investigated by the FBI right now either.

I would expect a good manager to recognize a bubble for what it is, after all, there is literature on the subject that goes back over 150 years. I would also expect a good manager to have the inegrity and courage to go against popular opinion as necessary. A manager who does not act on his own convictions is not a leader, but yet another sheep.

Also, why didn't the mainframe manufacturer, that you use in your example, diversify and transition into other product lines if they knew market demand was changing? Maybe that company's real problem was a lack of flexibility? You make it sound like it was an either / or situation where cautious transition was not possible.
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[sniglet]

[TJ_98370]

sniglet -

Good discussion and thanx for explaining.

Another example may be how the Swiss mechanical watch industry was nearly wiped out when the digital / quartz watch was developed. Now that situation had to be a "black swan" event, yes?

[sniglet]

[TJ_98370]

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sniglet -

I reread this thread and if you are saying that the real estate / credit bubble would not qualify as a black swan event, I would agree to an extent.

I have not read any of Nicholas Taleb's writings so maybe I don't understand the full meaning of the black swan theory. Wikipedia defines it as a large impact, hard to predict, and rare event and the Sept 11, 2001 attacks are used as an example.

I think factors that you may not be considering are awareness and perception of probability. RCC and jon touched on these points. It has been reported that the 911 attacks were predicted as a possibility, but the small number of people who were even aware of the possibility and could have done something about it apparently considered the event improbable. (There are other opinions including those that claim that the current administration is stupid, but I won't get into that.)

The real estate / credit bubble would be a black swan event to people who believe that real estate always appreciates.

The demise of the mainframe would be a black swan event to those who believe that mainframes would always have a niche in the marketplace.

The impact of the digital / quartz watch on the Swiss watch-making industry would be a black swan event to those who believed that a watch is a finely crafted peice of jewelry instead of just a tool from which you can tell time.

If everyone had perfect awareness, I would agree that black swan events are fallacy.

[sniglet]

[rose-colored-coolaid]

[TJ_98370]

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sniglet said:

Well, every event is a surprise to someone. So maybe the definition of a "black swan" is all about the perspective of the individual. You might have been the only one not to realize the oncoming train was going to hit your car, but if you were still surprised, then the train was a black swan...
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If you go by the Wikipedia definition of "Black Swan", a person being hit by a train would not qualify as a black swan event because it would not have a "large impact" (Unless you are the person being hit. It's hard to imagine an impact larger than being hit by a train )

I would totally agree that a black swan event is dependent on the perspective / awareness of the individual. Were the 911 attacks a black swan event to the analysts who predicted them?
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