The Black Swan

The Impact of the Highly Improbable

Book by Nassim Nicholas Taleb

Article and Review by GlobalMacroForex

If you have the belief that all swans are white, a single black swan will invalidate your theory.  This “black swan” metaphor has become a catchphrase in the financial services industry for events that cannot be predicted and invalidate previous ways of thinking.  Author Nassim Nicholas Taleb’s book has gotten a cult-like following from the hedge fund community.  The book shows the potential sudden random dangers in the market and how to position one’s portfolio to benefit from, rather than be crippled by, such events.  While I highly recommend you read the entire book, in this brief summary outline, we will cover topics the major topics including:

·      Black Swans

·      Flawed interpretations

·      Probabilities of Narratives

·      Spontaneous Order

·      Barbell investment strategy

Let’s dig right in… 

Black Swans

The book’s central premise is that life doesn’t just move forward at a steady pace, but it rapidly skips forward in unequal ways, with unpredictable “black swan” events quickly changing the entire world in ways that nobody could have predicted.  He gives examples, such as September 11th, the internet, entire religions, and prolific authors. 

Nassim Taleb is extremely skeptical about “experts” who claim they can predict the future like GDP or what durable sales will be in the next quarter.  He argues we are predisposed to trust experts in every field, but some fields can’t have experts.  Even though we may know that it’s impossible, we listen to them anyway.  Taleb argues that life is non-linear.   It takes rapid unexpected twists and turns that can’t be predicted and put into a financial Excel model.

“By removing the ten biggest one-day moves from the US stock market over the past fifty years, we see a huge difference in returns-and yet convention finance sees these one-day jumps as mere anomalies.”

Taleb points out the irony of a German Deutschmark having a Gaussian curve and literally Carl Friedrich Gauss (the mathematician who created it) on it, when the Germany currency itself hyper-inflated after World War I.  That hyperinflation itself was a non-standard normal event and itself invalidates the idea that currencies move in a predictable Gaussian world.

Instead of assuming everything is Standard Normal, Taleb urges us to listen to people like Benoit Mandelbrot, who offers us fractal geometry which studies the volatility or non-smoothness of objects.  I encourage you to read my article on Benoit Mandelbrot’s book.

Flawed interpretations

An interpretation is a reason for something happening.  Nassim Taleb points out how we are programmed to make up reasons, narratives, and interpretations for things.   Because information is hard to store in our brains and takes up a lot of resources, we look for shortcuts.  If we can find a pattern in the data, then we need only remember part of it and reconstruct the data in our minds.  Imagine random numbers vs. numbers that keep increasing by 2.  It’s obviously much easier to recall the second group of numbers because one can generate the numbers by formula. 

“The same condition that makes us simplify pushes us to think that the world is less random than it actually is.”

Taleb points out how memories are not static or set in stone.  In fact, our memories and stories change with every remembrance. 

This is a process known as reverberation, and it even further distorts our ability to form predictions because we change how we viewed the past to conform to our new prediction or pattern.  Even “objective” scientists, who are supposed to be immune to these types of false interpretations are just as easily mislead into narratives like the rest of us because they are not dispassionate third parties but overestimate the likelihood of their narrative being true.

Probabilities of Narratives

Not only do people create false narratives, but they overestimate the odds of something happening if a narrative is given.  Taleb gives us the example of a study asking people, which of the following scenarios is more likely:

Scenario A) A massive Flood somewhere in America, in which more than a thousand people die

Scenario B) An Earthquake in California caused massive flooding, in which more than a thousand people die

Most people pick B because a reason is given.  Once they can formulate a narrative and a reason for the event happening, the odds of it become more likely.  This stems from our inability to process events without a narrative or interpretation behind it.  We don’t like the idea that things happen just because.

On a similar note, Taleb points out that when bringing an event to someone’s consciousness, the individual overestimates the probability of the event happening merely through recent exposure to that idea.  Both the left and right schools of economic thought — from Minsky’s Neo-Keynesian school to Austrian economists — document how when there is no crisis, people are willing to take more risks because the likelihood of a crisis occurring is considered low by market participants.  Then once the crisis does occur, suddenly market participants overestimate the likelihood that it will occur again, because it has been brought to their attention and through this recent exposure they extrapolate false probabilities of it occurring again.

Spontaneous Order

Taleb argues we are not good at evaluating the unseen effects and brings up the famous past laissez-faire writers who originally suggested these ideas.  Frederic Bastiat, the nineteenth-century writer, and political economist discussed the unintended consequences of government.  When the government creates a job, we only see the job that is created.  We fail to see the new entrepreneur who would have created a job (had his wealth not been taxed away to allow for the first one).  Bastiat asked, “should we block out the sun to protect candlestick makers?”

Taleb points to September 11, 2001, when 2,500 people died in the twin towers.  He points out how nobody talks about the 1,000 more people who died in auto accidents in the next few months because they were afraid to fly and driving has a higher rate of fatality then air travel.  Are these people not also victims of Bin Laden?  We tend to ignore the second-hand effects or non-obvious consequences and thus believe governments when they suggest certain policies worked.

Taleb brings up the Nobel Prize-winning Austrian economist Fredrick Hayek, whom Taleb is surprised even won a Nobel because his acceptance speech was lamenting “expert economists” who say they can predict or know things in the future.  Hayek referred to it as the “fatal conceit” of government planners who think they can know what the market should do.  Hayek argues no government planner can ever aggregate the mass of data in the market and make an arbitrary decision on what a price or production amount should be.  Life is nonlinear.

Instead, Taleb and the free-market predecessors that came before him suggest that the world benefits most from “spontaneous order,”  where each individual, acting in his own self-interest, can best evaluate how his (or her) business should be run.  Like the birds and the bees moving in harmony to create the interwoven complexity of nature, each business on its own seeks to maximize profit, but in doing so sets the exact price level, production amounts, and products that the market wants.  Through many decentralized decision makers, we achieve the best result without a government mandate from above.

Barbell investment strategy

Nassim Taleb warns us that we need the stamina to be able to invest following his strategies because it’s likely we will fail a little bit over time, be mocked or criticized by our peers, and hold out for a few large payoffs.

“If you are going for anything in life with a high probability of a small failure, but a small probability of a huge win, you need to have intellectual stamina for the long road.”

One of the strategies he suggests to us is the ‘Barbell,’ where one invests 85-90% in US Treasuries or something extremely safe, and 10-15% in something with an asymmetric payout such as far out of the money options with high leverage.   Taleb defines asymmetric payout as a limited or finite small loss, but a much larger payout.  He made a lot of money with this strategy in the 1987 stock market crash.

“I will never get to know the unknown since, by definition, it is unknown.  However, I can always guess how it might affect me, and I should base my decisions around that.”

To help us understand how we can make an asymmetrical payout, He gives the example of Pascal’s wager coming from the philosopher Blaise Pascal.

“I do not know where god exists, but I know I have nothing to gain from being an atheist if he does not exist, whereas I have plenty to lose if he does.  Hence, this justifies my belief in god.”

Taleb explains rather than focus on the probabilities of a rare event, instead focus on the payoff and benefits of an event if it takes place.  He tells us to seek out events with positive contingencies (i.e., good black swans), where an unexpected sudden event raises your payout.  Avoid things where the black swan will hurt you, such as serving in the military, catastrophe insurance industry, or homeland security.  The unexpected event ruins you.  On the other hand, if you’re a venture capitalist or a book publisher and you buy an idea at a very low cost, that unexpected black swan event can catapult you up.  However, avoid paying a high price for the idea (like a book or business) or the surprise black swan could be that you don’t sell as much as was expected to justify that high price. 

You want to have that 10-15% of your portfolio going to a variety of different asymmetrical payouts, so you are exposing yourself to the possibility of upside in a few different positive black swans.  However, Taleb says that this isn’t like collecting lottery tickets, which have a scalable exact payoff.  Here you are benefiting from the fact that exact ratios cannot be known, so by default they must be mispriced.

“This idea that in order to make a decision you need to focus on the consequences (which you can know) rather than the probability (which you can’t know) is the central idea of uncertainty.”

  Taleb tells us not to be too narrow-minded; be creative with your search and seize any and all opportunities for an asymmetrical payout.


This book is a hedge fund classic, and really drives home the point that black swan events do exist and completely change the investment landscape and life in general.  Nassim Taleb puts forth the flaws in conventional economic predictions, flawed thinking about narratives, and the incorrect probabilities of people exposed to narratives (such as with a stock market crash).    He argues life is nonlinear and doesn’t fit into a standard normal distribution.  Instead, Taleb encourages us to invest in asymmetrical payouts where we are exposed to a potential positive black swan, and the unpredictability of the situation works in our favor.