Fooled by the Black Swan

Is your organisation one black swan away from disaster? Are you taking hidden risks in the quest for success, and using hope as your only risk management tool?

Nassim Taleb’s books should be required reading for life

Nassim Taleb is one of my new favourite authors. I’m actually a little slow on the uptake here since I am currently reading his 2005 book “Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets.â€? meanwhile the New York Times has his current book “The Black Swan: The Impact of the Highly Improbableâ€? on their best-seller list. I wholeheartedly recommend “Fooled by Randomnessâ€?, and fully expect that once I have read his current book I will be able to do the same for that.

Dumb luck is a large contributor to success in an uncertain world

Do you want the success of your organisation to be at the mercy of dumb luck?

Nassim Taleb’s writings resonate with me, because I agree with them. He just has an infinitely more entertaining (let alone more convincing) way of explaining his viewpoints. One of his major themes is how poor our understanding is of randomness. And he’s not talking about the “average joeâ€? in the street. If anything, he is more scathing of those so-called experts of the financial markets who are made or broken largely by luck. The unlucky fall be the wayside not be heard from, whereas the lucky shout their own praises from the rooftops.

I am not going to go further into his arguments in this post – the book is worthwhile reading if you are interested. However, I do want to touch a theme introduced in Fooled, and further expounded upon (I assume) in “The Black Swan�.

At some stage, the sun is going to stop rising

In the not so distant past, it was assumed that all swans must be white. Every swan ever seen had been white. All the classical statistical inference would have attributed a 100% probability to all swans being white. Until the rather unfortunate discovery of a little place called Australia. Enter the Black Swan.

Don’t trust past experience blindly, and trust your intuition even less

In risk management terms (and when I talk about risk management I include managing an organisation in the face of uncertainty, which includes every organisation I have ever known), events that may seem extremely unlikely based on past information and experience may still happen. If the occurrence of a black swan for your organisation would be catastrophic, are you really prepared to just hope that the past experience to date accurately reflects the future?

Actuaries and risk management

“Actuaries only look at the past so they are Fooled by Randomness.” This is a superficial description of actuarial work. Without a doubt, actuaries look to the past to infer certain parameters about the future. I’m not convinced this is necessarily bad as long as one realises that the past is not all there is to the future. The impact of HIV/AIDS and annuitant mortality improvements are typical of areas where actuaries have recognised that the past does not reflect the future and attempt to adjust for this in their calculations. Actuaries have the unfortunate job of trying to accurately estimate what this unknown future scenario will look like, rather than recognising that the risks exists and managing it.

When it comes to managing potentially catastrophic risks, Mr Taleb’s preferred practice is to limit all risks no matter how unlikely they may seem. The good news here is that if the consensus view is that the risks are extremely unlikely, the costs of mitigating those risks (transferring, hedging, reinsuring, selling etc.) should be relatively low. Mr Taleb prefers to find ways to use past patterns to make a profit, but use a sophisticated paranoia when managing the risks. He goes further and aims to benefit from the occasional black swan that flies his way. Again, more of this in his very worthwhile reading books.

Understanding all these potential risks, and understanding the potential for financial or operational impact on your organisation is not easy. Some of the results can be counter-intuitive, and simply drilling through the analytical steps to get to practical, useful steps requires a combination of common sense, uncommon insight into risk, and a tool-set capable of meeting the problems head-on.

In general, the human mind is a pretty poor tool for understanding a probabilistic world and making good decisions in the face of uncertainty.

What makes a good decision?

As an aside, another element of Mr Taleb’s thinking that I read with a fervently nodding head is that in an uncertain world, decisions should not be evaluated based on the outcome, but rather on whether it was the right decision given the information available at the time the decision was made. This is also not to say that the outcome never provides any information about the quality of the decision, just that it usually doesn’t. For example, take the decision to call “headsâ€? on the toss of a “fairâ€? coin. If the coin dutifully lands heads up, does that make the decision a good decision? I would argue very strongly that it does not. A more difficult example to agree with is that of a fund manager selecting a particular stock. If it the share appreciates in value over some period, is that sufficient evidence to show that the “buyâ€? call was a good one? Again, I would argue that it doesn’t. Especially when there is a large selection of fund managers making calls on all manner of stocks on a regular basis. Some of them have to be right some of the time. And a few of them will be right a great deal of the time just through luck.

Do you have a Black Swan?

Now if your organisation has a currency exposure, perhaps you are importing a component of your production process, or maybe your sales are partly to a foreign country, should you be bullish on the exchange rate? Should you be tring to time the market? Or should you be managing your risk by removing the areas of uncertainty over which you have no control, and where you are likely to be less informed than most professional currency traders, and where those self-same professional currency traders are playing in a massively uncertain world, where those with good “track recordsâ€? are more likely to be lucky than skillful? What happens if the Black Swan of a sharp exchange rate depreciation (or appreciation) is enough to wipe our your year’s operational earnings?

“We can’t afford risk management”

A common response to the argument for risk management is that hedging (or reinsurance, or put options or credit guarantees or business interruption insurance) is expensive. As I alluded to before, if the risk really is that unlikely, the cost should be relatively low. If the cost is high, it may reflect that others have a more prudent view of the possibilities of those risks than you do, which should start the alarm bells ringing immediately. The other side is that do you really believe than an appropriate way to build and manage your organisation is to continually take a small but very real risk of a catastrophic risk in order to make additional profit? If that is the primary source of profit for your organisation, then the fundamentals of that business may need to be revisited. Selling far out of the money naked call options as an income source may never get you into trouble and yield a modest revenue stream. Very few would agree that this is a good long-term strategy for success. A good number of the few that do have already been burnt in the process.

So what now for understanding and managing risk?

So there are four major points I would like to conclude with:

  1. If you operate an organisation, you operate in an uncertain world and are exposed to risks

  2. Just because you have never seen a Black Swan, doesn’t mean you will never see one.

  3. If there is a risk that could severely damage your business (a Black Swan), you had better have a better risk management strategy than closing your eyes and hoping

  4. Identifying these risks, measuring them and understanding their impact on your business, and then understanding the options available to you in managing those risks is an important and non-trivial exercise.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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  1. Hi David,
    Good article. I read the book “Fooled By Randomness” it was great. I think every business owner should read it.

    Coming back to the Black Swan, I think most people don’t know ALL the possible outcomes. They may think that they understand their risks, but have they really done their homework. I like his idea about using the Monte Carlo simulator, but again, Garbage-in-garbage-out. How many small businesses have the technical skills to find all the possible outcomes and to try and identify the risks involved?. If you could simulate every business risk/transaction, would entrepreneurs be in business? I agree that you need to understand the business in which you operate and the risks involved. But for example we all know that South Africa has a high mortality rate on our roads, does that mean that a person who has done his home work about car accidents and run this through his Monte Carlo simulator – should he get in his car or not? The fact is that we HAVE to drive our cars to work (but how can we reduce the chance of an accident, is that even possible ie the black swan). Is this not so with our businesses, most people know that there are currency/political/economical risks, should we do the business or not? Like I said earlier, not all business has the technical skills to identify the risks – especially the SME, where the entrepreneur is the business. He has started his business because he is a specialist in his field, but he doesn’t know about accounting/business risk/currency risk etc. So how do we tackle this problem in our country?

  2. I agree that there are very definite challenges in understanding and managing risks for any business. Large corporations throw a lot of money and resources at the problem, but often without senior management appreciating where their business is actually out on a limb.

    An example is commodity extraction industries, where hedging future production is popularly considered as a “bad” decision. Most of this taint has come from outside analysts and commentators seeing the companies lose out on favourable price increases because the companies had a hedge in place. This is a typical example of how the decision to hedge or not hedge cannot be evaluated based on the outcome of the commodity price in question. The whole point of the hedge was to remove the exposure to uncertainty, to remove the risk exposure to events out of the control of management.

    While practical Monte Carlo simulation is unlikely to be worthwhile for an SME, I understand Mr Taleb’s comments as more of a thought experiment than a suggestion to actually simulate everything. The real value is in understanding how the actual path taken could have been different. This is more important than modelling specific possible outcomes. With an understanding of risk, better strategic decisions can be made even without detailed measurement.

    On the topic of entrepreneurs, I think I would answer your question as “Yes, exactly!“. Many entrepreneurs take risks. Some are successful; some are not. By definition, those that write books and give seminars on how to succeed are the successful ones. Their risks paid off. However, if one took a true sample of entrepreneurs without “conditioning” on success, I’m not at all sure that unconsidered risk-taking is necessarily a good thing, and many considered risks probably will turn out to have a negative expected outcome or “Return on Investment” as well.
    The statistics (I don’t have any on hand) about the success of new businesses show a depressing picture – more fail than succeed. If this is the case, then I taking risks doesn’t sound quite as attractive as it did when only considering the winners. Mr Taleb uses the example of Warren Buffet as someone who may have skill, or may just have been lucky – with the number of people buying and selling companies, basic laws of probability would likely produce someone with Warren Buffet’s track record entirely without skill. For entrepreneurs, the same lessons apply. Richard Branson springs to mind.

    It’s also clear that many risks (particularly operational and political risks) are very difficult to mitigate. However, the risk management opportunities currently available to SMEs cover a broad range of very real, very serious risks. I’ve already mentioned business interruption insurance and credit guarantees. Some other forms of insurance include key person risk and professional or public liability insurance. In terms of exposure to financial markets, for SMEs this exposure will relate mostly to interest rates and exchange rates. With YieldX and the large number of retail-relevant financial instruments available on the broader JSE, hedging currency risks and interest rate risks becomes accessible and cost-effective, whereas even a few years ago it would have been prohibitively expensive and in many instances restricted by regulations.

    If the cost of this sort of risk management is “too high”, then this might indicate that your business plan doesn’t have a real competitive advantage, but is relying on luck to succeed. It may succeed, or it may not, and this outcome will be out of the entrepreneur’s hands. A coin that lands heads rather than tails isn’t a “better” coin that one than lands tails, and wouldn’t be expected to “succeed” in future at generating heads more often than tails.

    To move away from practical examples though, the key point for SMEs in South Africa (and any country) is to understand very carefully what risks are being taken, and apply critical thinking to “success stories that prove how risk is a good thing”. The answer isn’t necessarily to throw in the towel and become a dentist (Fooled by Randomness’s typical low-risk example job). However, once you have understood the principles and become attracted to the low-risk high-self-determination, low-rely-on-dumb-luck opportunities, you have understood the problem of uncertainty and will not be as easily Fooled By Randomness. Then you are prepared to face randomness.

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