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October 03, 2007

A Turkey Connects the Wrong Dots and Finds a Black Swan

The Black Swan by Nassim Nicholas Taleb is simply a great book. Not flawless, sometimes annoying, always stimulating, but overall great. Here’s an example about connecting the wrong dots:

“Consider a turkey that is fed every day, Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”

Back to the title: doesn’t matter how many white swans you see in a row; they don’t prove the non-existence of black swans. On the other hand, you only need to see one black swan to DISPROVE the proposition that all swans are white. That’s why good thinkers in general and good scientists in particular set out to DISPROVE rather than affirm their own hypothesis. You don’t add much credibility to the “all swans are white” theory by finding yet one more white swan; you learn a lot about the truth of the theory by finding one black swan.

Black swans are, according to Taleb, unexpected and unpredictable rare events. By their nature, we can’t know which black swans are about to reverse an orderly flow of dots and shatter our complacency; but, by the nature of the universe, we can be sure that sooner or later one will come along. Black swans can be good or bad: a book becoming a hit (unpredictable), suddenly becoming rich (or poor), the Internet, the rise to dominance of Google – all examples given by Taleb.

If you think that each day that a stock or a class of stocks goes up makes it more likely that owning those stocks will make you rich, you’re making the same mistake as the turkey. Actually, it’s statistically true that a stock is slightly more likely to go up than down on the day following an up day, but the odds of losing rather then making money on the stock go up rather than down following a rise. That’s because a decline, even though it is less likely than an advance for a stock with “up momentum”, is more likely to be big. A stock or a market which has been rising quickly is more and more vulnerable to a black swan event.

Taleb honed his skill as a trader but applies the black swan (and Fooled by Randomness) lessons to much more:

“The turkey problem can be generalized to any situation where the same hand that feeds you can be the one that wrings your neck. Consider the case of the increasingly integrated German Jews in the 1930s – or my description in Chapter 1 of how the population of Lebanon got lulled into a false sense of security by the appearance of mutual friendliness and tolerance.”

Being a Jew born during WWII, I was brought up on the first example. Taleb is Lebanese and grew up there as the country went from peace and prosperity to a chaos which still hasn’t ended.

The Black Swan is a book of contradictions. Taleb warns us against our predilection for making up stories to explain events yet he is a master story teller himself; his books work better because we learn through well-told stories like the fate of the turkey.

Taleb warns us against the fallacy of thinking that a trader who is rich is necessarily smart; very likely that she or he is just lucky. After all, if hundreds of thousands of people start out as apprentice traders – and if all trading were governed by pure luck, at the end of a year randomness would assure that there were some who were extremely successful as well as a whole bunch of losers. But Taleb’s credibility comes partly from HIS success as a trader. He’s even written a book on his techniques called Dynamic Hedging, which I’ve ordered. I’ll let you know if it makes me rich – maybe.

Taleb loves to puncture arrogance and does so fiercely and effectively – Nobel laureates in Economics are a particular target; but Taleb is quite arrogant himself, says he has no intent or reading random reviews and please don’t send him notes about typos or how to make his website better (it’s a mess).

But read The Black Swan if you haven’t.

Random thought: Hansel DIDN’T make the turkey’s mistake. He figured out why the witch was fattening him up and, every day, gave her a skinny stick rather than his fat finger to test for plumpness. Skepticism is a good but not infallible weapon against black swans.

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