Tuesday, August 22, 2006

Black swan stops play and Gambler's Ruin

On Sunday I saw my first real black swan - and it wasn't a Cygnus atratus on a Sunday excursion. What I did see first hand was "a large-impact hard-to-predict rare event beyond the realm of normal expectations". Obviously I am referring to the 4th day of the England v Pakistan incident-fest which I happened to be at the Oval to see. I have also been recently reading Nassim Taleb's book on randomness and unpredictable events and this Sunday brought the message home fairly spectacularly.

Black Swan was a term originally used by the economist David Hume in a slightly different context. Hume pointed out that a conclusion that all swans are white cannot be logically drawn from any number of observations of white swans. However, just one observation of a black swan is enough to prove the converse - all swans are not white. The point here being to indicate the asymmetrical nature of rational deductions and how easy it can be to fall into logical traps. Taleb uses a slightly broader suggestion to use the term to refer to rare, high-impact events in general. September 11 was a classic black swan event - random, high impact and one most people are totally ill-equipped to comprehend.

The basic idea that Taleb puts forward is that human brains are not wired and calibrated to deal with such random and high impact events which occur more frequently than we think. For this reason, there may be opportunities to profit from the mispricing that occurs around these areas. Arguably, an Enron was a classic black swan opportunity. There was a time when Enron was a wall street darling and featured in Fortune as America's most innovative company 6 years in succession - and then it suddenly and spectacularly imploded. A speculator shorting Enron through the late 90s would have made an absolute killing.

Similarly, yesterday before Mr. Hair decided he could use a little attention, England were 250-1 to win the test match and within 30 minutes, they had been declared winners through a bizarre combination of events that has never happened before in the history of test cricket. Again a massive speculation opportunity for anyone who had taken a punt.

There is no doubt that black swan events do tend to lead to irrational and emotive thinking. An example is the current security checking regime at UK airports. If you step back and think, there has never been an actual case of someone smuggling liquid explosives on to an aircraft at a UK airport - the alleged conspiracy was just that and may or may not have worked. However, there HAS been an actual incident where people have successfully walked on to a tube train and blown it apart so there is clear evidence that can be done. However, no one seems to be rooting for increased security on the tube even when it has been shown with 100% certainty that it can easily be breached. At the same time, there is all manner of 'stringent' additional security checking when there is no actual evidence that the previous security regime wouldn't have worked anyway ! Another example is that when most people are offered insurance policies protecting them against either terrorist strikes or general loss, most people in a climate of fear choose the former even though it is covered by the latter. Basically our mental processes break down when confronted by randomness.

In this New Yorker article, Malcolm Gladwell refers to an investment strategy that Taleb follows to exploit mispricing in black swans. Very simply, his method seems to be to bet on low probability, high impact events and be willing to lose money on most trades in the belief that a large win on a black swan would more than compensate. The theory is seductive in its contrarianism and simplicity but has the obvious problems of limited funds. It isn't totally clear how Taleb would avoid Gambler's ruin. I guess one way is to keep attracting fresh funds at a rate higher than his general burn rate. In any case, there isn't a convincing argument that you can do very well exploiting real black swans by keeping on betting on improbable events in the hope that one spectacular payday will make up for all the bleeding. So while Taleb is right when it comes to the concept, it is hard to see that as a basis for an investment philosophy.

1 Comments:

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