Monday, 11 February 2008

The Black Swan

You’re in England and you ask a kid to see if all swans are white. He gets out into the field and starts counting. He’s up to 20 and all of them are white. He counts 100 – and asks if he can stop now. You say no and ask him to continue counting. He’s up to 1,000 and every single one of the swans he’s counted is white. What’s the point he asks? It’s approaching dusk, he’s physically exhausted and he’s counted 3,781 swans. All of them white and none of any other color.

What’s your conclusion you ask?

All swans are white of course!

Sure on that?

Yeah I’d bet my life on it!

Anyway a short while later, the parents take the kid to Australia to visit his auntie who has emigrated there and lives in Tasmania. He has a great time in Australia, but then to his horror - as he remembers the bet that he has made with you - he sees a beautiful Australian black swan pass by a short distance in front of him…

Black Swan

The black swan (or unexpected event) doesn’t come by very often but when it does it causes all sorts of havoc. The airplane that took off safely 2,881 times is now lying at the bottom of the sea. The plunge in stock prices during a bull market.

Humans don’t like black swans of course. And many also naively believe that we have the power to prevent black swan events from happening in the first place! As if we could somehow circumvent the laws of probability theory and do away completely with airplane disasters, traffic accidents, floods, famines, flu pandemics, stock market crashes, and currency devaluations.

Utopia anyone?

Footnote: the idea of the black swan is now becoming very important in understanding randomness in financial markets and explaining why stock market crashes take place. A lot of the basic groundwork was laid by the British/Austrian philosopher Karl Popper, whose methods can be used to show that many so-called experts (bankers, financial advisors, politicians, property brokers, etc) are basically no more than mere charlatans. More on that to come in future posts.