The Black Swan Theory | The Occurrence of the Statistically Improbable

Financial lore is replete with references to animals. One animal that is rarely seen, yet alone spoken about is the black swan. It is what gave rise to the term ‘black swan event’.

The black swan theory, which was developed by Nassim Nicholas Taleb, is based on an ancient saying that presumed black swans did not exist. After black swans were discovered in Australia, the term was reinterpreted to teach a different parable.

In finance, a black swan is an unpredictable event that is beyond what is normally expected of a situation and that has severe ramifications. Black swan events are characterised by their rarity, strong impact and the insistence they were obvious in hindsight.

For extremely rare events, Taleb argues that the standard tools of probability and prediction–such as the normal distribution–cannot be utilised. In the field of statistics, the normal distribution depends on large population and past sample sizes. This data thus cannot be used to predict rare and statistically improbable events.

Part of the problem lies with the fact that since these events are outliers that occur with low frequency, they are not treated with high regard in realms where highly frequent observations are given more weight in decision-making.

Even extrapolating–the process of using statistics based on observations of past events–is not helpful for predicting black swans and may even make us more vulnerable to them. When it comes to the occurrence of a black swan, observers tend to explain it after the fact and speculate as to how it could have been predicted.

It has been argued that this retrospective speculation does not actually help to predict black swan events.

The 2008 Global Financial Crisis is one of the most recent and well-known black swan events. The effect of the crash had huge ramifications and only a few were able to predict its occurrence. The dotcom bubble of 2001 is cited as another black swan event due to the similarities it has with the GFC.

In both scenarios, the American economy was enjoying rapid growth and increases in private wealth before the economy suddenly collapsed.

When it came to the dotcom bubble, the explanation offered after the fact was that since the internet was still at its early stages in terms of commercial use, various investment funds were investing in technology companies with inflated valuations and no true market traction. When these companies shut down, the funds were hit hard and the risks were borne by investors.

As the digital frontier was new at the time, it is argued that it was nearly impossible to predict the collapse.

The lesson of the black swan is that what we think to be implausible events may occur; much like the black swan from down under.


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