Model uncertainty

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 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 

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. 

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