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The Lucky Innovator

By Stuart Crainer and Des Dearlove

“An extraordinary, almost unimaginable sequence of events.” That is how Mervyn King, Governor of the Bank of England, described the circumstances that plunged the world banking system into crisis following the collapse of Lehman Brothers on September 15, 2008. “It is difficult to exaggerate the severity and importance of those events,” he added. “Not since the beginning of the First World War has our banking system been so close to collapse.”

What King was describing is known as a “black swan”, a term made famous by Nassim Nicholas Taleb in his book, The Black Swan: The Impact of the Highly Improbable (2007). In it, Taleb refers to “large-impact, hard-to-predict and rare events beyond the realm of normal expectations”. As examples, he points to the creation of the Internet as well as the terrorist attacks of September 11 as prime examples of recent black swans. Indeed, he argues that most big moments in history are caused by black swans.

The phrase “black swan” originally comes from the belief for centuries that all swans were white — an assumption based on the fact that no one in the West had ever seen a black swan. Western philosophers, including Aristotle, used the idea of a black swan to illustrate the improbable, in much the same way that we might refer to those other rare animals, flying pigs or pink elephants. Yet, ironically, this changed in the 17th Century with the discovery of black swans in Australia. As a result, the phrase came to mean the exception to the rule.

For Taleb, “black swan”, with its dual meaning, was an irresistible concept to use in discussing world affairs. In Taleb’s case, he didn’t need another person to debate the reality of black swans: on the one hand, he argues that flawed assumptions blind us to the possibility of black swans — for example, that a long-time, upward progression of stocks or home prices can never reverse course and fall. On the other hand, he notes our tendency to imagine there are rules and patterns — for example, that the inevitable reduction in the supply of oil means prices will spike ever higher — but concedes that such rules do not really exist.

Taleb knows all about potentially devastating events from his upbringing in Lebanon. His grandfather and great grandfather both served as deputy prime ministers, and his other grandfather was a supreme court judge. But the family lost much of their influence and wealth in the Lebanese civil war that started in 1975 (his own black swan). Taleb described the experience as going from “paradise to hell”.

As a young man, he worked at several banks, including UBS and Credit Suisse First Boston, observing the machinations of the financial system with his own eyes. He also earned an MBA from Wharton and took a PhD in management science from the University of Paris-Dauphine.

Taleb’s own epiphany came in 1996. Then a young Wall Street trader himself, he was invited to meet Victor Niederhoffer, one of the most successful money managers in America. Niederhoffer worked from his mansion in a 13-acre compound in Connecticut, complete with swimming pool and tennis courts. Wall Street legend George Soros was a regular visitor. Niederhoffer had a PhD in economics from the University of Chicago and had pioneered the idea that statistical analysis of patterns in the market could enable investors to identify and exploit profitable anomalies. So impressed was Soros that he even sent his son to work for Niederhoffer to learn how to make such investments.

When he arrived at Niederhoffer’s place in Connecticut, Taleb was impressed by the opulent surroundings. But he couldn’t shake the nagging thought that his host’s success might be based not on superior analysis, skill and insight — but on luck. “For Taleb, the question why someone was a success in the financial marketplace was vexing,”

In 1997, less than a year after Taleb’s visit, Victor Niederhoffer’s luck ran out. Niederhoffer decided to buy Thai bank stocks, which had fallen heavily in the Asian financial crisis; his bet was that the Thai government would not allow these companies to go out of business. On October 27, 1997, losses resulting from this investment, combined with a 554 point (7.2 percent) single-day decline in the Dow Jones Industrial Average forced Niederhoffer Investments to close its doors. In Wall Street terminology, Niederhoffer had blown up.

The news confirmed Taleb’s misgivings. Indeed, so convinced was Taleb about his own point of view that he set up his own firm to help clients safeguard their money from the devastating effects of black swans.

Taleb believes that human beings prefer to ignore black swans because they are more comfortable believing that the world is structured, understandable and therefore predictable. He calls this blinkeredness the “Platonic fallacy”, which leads to three distortions. First is the narrative fallacy, the tendency to create a story post hoc to explain what has already happened. In this way human beings reassure themselves that an event had an identifiable cause. The second distortion is the Ludic fallacy, the tendency to believe that the structured randomness found in games resembles the unstructured randomness found in real life: we perceive rules at work where there are none. Third is the statistical regress fallacy, the tendency to believe that we can understand the probability that an event will occur based on a set of data. Together, these create three illusions:

  • An illusion of understanding current events
  • A retrospective distortion of history, and
  • An overestimation of factual information combined with an overvaluation of the intellectual elite

Controversially, Taleb also argues that most universities are better at public relations and claiming credit than they are at creating knowledge. Taleb is against grand theories in social science. He supports experiments and fact collecting but is against Platonic theories that are not supported with hard data. Indeed, he doesn’t even like his own ideas to be described as theories. He prefers to call concept like the black swan merely a “conjecture” of his.

Taleb calls himself a “skeptical empiricist”, believing that scientists, economists, historians, politicians, businessmen and financiers are all victims of the illusion of pattern. They overestimate the value of rational explanations of past data and their ability to influence future events. In this, he follows in a long line of thinkers including Socrates, David Hume and Karl Popper.  Lucky company.

Resources

Nassim Nicholas Taleb, The Black Swan, Allen Lane, 2007

This was originally published in What we mean when we talk about innovation by Stuart Crainer and Des Dearlove (Infinite Ideas, 2016).

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