Beware the Black Swan

I’ve been babbling for several months now on this blog (and, as my wife can attest, for several years before that) about the risk of low probability, high impact events–what Nassim Taleb refers to as Black Swans–particularly related to the housing market.

It seems that chicken may finally be coming home to roost in the housing market and the markets that rely strongly on the housing industry.

Before I crow too loud about the malaise that is occurring, I must freely admit that I did not place any money-making bets on this decline. Quite the contrary, all I did was try to stay away from such a risk.

In staying away, I missed out on the huge run-up that has occurred in mortgage lenders, mortgage insurers, bond insurers, home builders, etc. This made me look pretty stupid in the short run, but right now I’m quite happy I don’t own any companies in these industries.

Will these industries face a total collapse or a financial crisis? I have no idea. The odds are against it. But, like all Black Swans, I want to avoid such negative, low likelihood, high impact events.

I don’t have to be able to predict when they will happen or how bad it will get, I simply have to stay away from risks I cannot accurately assess or that do not provide sufficient compensation for their risk.

I will be very interested to see how bad such housing related markets get, but I still don’t think I’ll be participating there for quite some time. After all, because it seems to be a Black Swan, I don’t know how bad it will get, and so I’m staying away until I understand what’s going on.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Black Swan

I have another excellent book to recommend: Nassim Taleb’s Black Swan (Taleb also wrote another favorite: Fooled by Randomness)

The book deals with a subject I’m always thinking about, the impact of improbable events. Taleb is an trader who seems to have made a career out of betting that improbable events may happen more frequently than most people predict, so he knows of what he speaks.

Taleb describes two countries, Mediocristan and Extremistan, which have very different characteristics. In Mediocristan, everything follows a bell shaped curve and is relatively easy to predict. He gives the example of the income of dentists, which tend to fall around an average and not vary too far from it. In Extremistan, however, things don’t follow a bell shaped curve and are almost impossible to predict. He gives the example of authors whose incomes are either extremely high (for very few) or extremely low (for the vast majority).

The reason he highlights this difference is a lot of people, especially academics in economics and finance, tend to assume that we live in Mediocristan even though we live in a world that resembles both Mediocristan and Extremistan. The height of people and the income of dentists are bell shaped, financial markets and the income of authors are not. The problem is that highly improbable events can easily overwhelm the highly probable events that most people focus on.

His point is important to acknowledge, because if you are measuring the height of people, bell shaped curves are great. But, if you are operating in financial markets, using bell shaped curves can be very dangerous (just ask the Nobel prize winners who worked with Long Term Capital Management).

I’m finding the book a pleasure to read because the subject matter is fascinating and relevant, and because I really enjoy his style of writing, which is laced with stories, examples and no punches pulled. Sometimes, he seems to be a bit arrogant in his way of describing things, but I’m usually more amused than offended by this.

I highly recommend the book to anyone operating in Extremistan for a living.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.