Model uncertainty by TAPEN SINHA The author makes the valuable contribution of making us aware of "black swans" that could be lurking in the financial market. NASSIM NICHOLAS TALEB'S book (The Black Swan: The Impact of the Highly Improbable), analysing financial systems, has become a bestseller. In the process, it has also become a must-read for financial analysts of Wall Street. Taleb, who hails from a highly respectable Lebanese Christian family and whose grandparents and great-great grandparents were high government officials in various regimes, saw his entire family fortune vanish practically overnig ht in the Lebanese civil war of 1975. One suspects that memories of this trauma have influenced his views. What is a black swan? If you had lived all your life in the northern hemisphere, all you would have seen were white swans. You would conclude that all swans are white. This is exactly what the Europeans of the 18th century concluded before they went to Australia where they found only black swans. Thus, the metaphor of the black swan is used to denote anything that appears impossible on the basis of a limited number of observations. In modern statistical parlance, it would be called a "model uncertainty". More precisely, it is what happens when we use a model to predict some future events but the underlying model is wrong and we do not even know that the model is wrong. To paraphrase Mark Twain: It's what you don't know you don't know that gets you into trouble. In January 1995, the Barings Bank lost £827 million ($1.4 billion), twice the bank's available trading capital. It went bankrupt in February that year. The architect of that failure was a rogue trader named Nick Leeson. Since he operated as a trader in the front office and was the person who processed the trade in the back office, he was able to hide his activities from his superiors. At first, he took several uncovered positions and lost a few million pounds. Then he took bigger bets to recover the losses. However, the Kobe earthquake of January 1995 produced a figurative earthquake in the Japanese futures market that amplified the loss to the billion-dollar range. This was an unexpected event in the market. Nobody expected Kobe to be so badly damaged, given that all possible measures had been taken to ensure that the city would be able to withstand such an earthquake. And nobody expected that an earthquake in Kobe could ruin a British bank that had been in continuous operation since 1762. This was a black swan. Most large banks take measures to stop trading that allows both the front and the back office to be controlled by the same person. This is supposed to be a standard risk management practice. Societe Generale, France's second largest bank, took such practices seriously. In fact, the magazine Risk declared early this year that among the large banks in the world, Societe Generale had the best risk management process in place. Yet, this did not stop Jerome Kerviel, a trader at Societe Generale, from taking an unhedged unauthorised bet in the European futures markets. Once again, it turns out that he had control of both the back office and the front office. This time, the undoing came about when the Federal Reserve of the United States unexpectedly dropped its official interest rate in late January. In the end, Kerviel caused a €4.9-billion ($7.2-billion) trading loss to Societe Generale, which could spell its end. These are examples of operational risk gone spectacularly wrong. They are black swans. Where are these black swans in our lives? According to Taleb, they are everywhere. In particular, there are black swans in financial markets. The standard statistical models (the bell-shaped curve of the normal, or Gaussian, distribution) used in standard financial models underestimate the chances of high-risk events. Events that actually occur once every decade are often modelled as if they occur once in 100 years. This creates the false impression that we can ignore events that should not be ignored. Black swans are real. They are even more real in developing countries such as India where the financial market is inherently much more volatile than its counterparts in the developed world. Indians have two bad habits. First, we consider Western-trained Indians to be superior to home-grown ones. Western-trained financial experts acquire a Western mindset. They tend to ignore problems that typically arise in markets that are "thin" -- most of the companies listed in Indian stock exchanges hardly ever have any trade. Thus, their training does not prepare them to spot black swans. They are like the 18th century English who had never seen a black swan. >>Business Chennai, April 25, 2010 Updated: April 25, 2010 12:32 IST Stocks and swans D. Murali A black swan is an outlier One of Taleb's earliest Wall Street mentors was Jean-Patrice, who had an almost neurotic obsession with risk, informs the book. "Once Jean-Patrice asked Taleb what would happen to his positions if a plane crashed into his building. Taleb was young then and brushed him aside. It seemed absurd. But nothing, Taleb soon realised, is absurd." Taleb likes to quote David Hume, one learns: "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion." A black swan is an outlier, an event that lies beyond the realm of normal expectations, explains Taleb in an op-ed in The New York Times dated April 8, 2004. "Most people expect all swans to be white because that’s what their experience tells them; a black swan is by definition a surprise." Nevertheless, people tend to concoct explanations for them after the fact, which makes them appear more predictable, and less random, than they are, Taleb finds. "Our minds are designed to retain, for efficient storage, past information that fits into a compressed narrative. This distortion, called the hindsight bias, prevents us from adequately learning from the past." Sadly, 9/11 was 'a black swan of the vicious variety.' Trading philosophy What is Taleb's approach to trading? A philosophy predicated entirely on the existence of black swans, on the possibility of some random, unexpected event sweeping the markets, writes Gladwell. Taleb doesn't invest in stocks, because buying a stock, unlike buying an option, is a gamble that the future will represent an improved vision of the past; and who knows whether that will be true, the author informs. The investment is, instead, in Treasury bills. "If anything completely out of the ordinary happens to the stock market, if some random event sends a jolt through all of Wall Street and pushes GM to, say $20, Nassim Taleb will not end up in a dowdy apartment in Athens. He will be rich." For the investment-avid, a page about GM in Wikipedia has a time-lined history of the company that saw its share falling to as low as $1 in May 2009… Essays of engaging and timeless nature that Gladwell fans would love to read and re-read.