LAUSANNE, Switzerland — To anyone dealing in finance or economics, a “black swan” is an unpredicted event, usually a catastrophe along the lines of British Petroleum’s Gulf of Mexico blowout, the impact of Iceland’s volcano on international air traffic or the financial crisis itself.
Nassim Nicholas Taleb, who introduced the idea in 2007 in his book entitled, “The Black Swan,” was in Lausanne recently to address an auditorium filled with corporate CEOs and upper echelon management attending an executive training program at IMD, the international Institute of Management Development, which the Economist magazine ranks as one of the best in the world.
Taleb is a leading theoretician on financial risk. "The Black Swan," which has sold 2.7 million copies in 31 languages, was described by the Times of London as one of the 12 most influential books to be published since World War II. Reports are that it impressed a number of writers, including Malcolm Gladwell and Britain's Prime Minister David Cameron.
Taleb clearly thinks that more disasters along the lines of the Gulf of Mexico are waiting down the line and that we are woefully unprepared to predict their occurrence in advance or to deal with them once they happen, and he blames an overreliance on theory for some of the most seemingly insoluble problems troubling us today. As Taleb sees it, economists have a tendency to extrapolate from past events in order to create modern-day efficiency, but what looks like efficiency today actually increases our vulnerability to the one-in-a-million risks that have no historical precedent and which no one can be expected to predict in advance.
Current trends and recent history can also be dangerously misleading. Taleb uses the example of the Thanksgiving turkey that is being fattened up for slaughter. As the turkey sees it, daily experience reinforces the image of the butcher as a benefactor who can be counted on to provide delightful delicacies on a daily basis — a good friend — right up until the day when the butcher reveals his true intentions. For the turkey the final day of reckoning is a personal black swan event. Leading up to the finale, the turkey clearly misinterprets what is happening around it.
“It is not a good idea to be a turkey,” Taleb said, but he adds that statistics and numbers often turn us into our own version of the proverbial turkey. “When you have numbers, you tend to take greater risks, even when the numbers are totally random.”
The stock market is a case in point. Its impact on business, Taleb points out, is to favor an emphasis on steady growth and stability while downplaying risk. “There is an incentive to engage in strategies that create cosmetic high returns, but which may fragilize you enormously,” he said. “The entire business in the U.S. became based on hiding risks.”
Several factors substantially increase our vulnerability to risk today. An unexpected event is likely to have far fewer consequences when businesses and especially banks are relatively small and widely diversified. The consolidation of banks and corporations like General Motors into huge institutions is largely responsible for the phenomenon in which some businesses have become “too large to be allowed to fail.” The taxpayer is inevitably forced to pick up the tab.
A growing dependence on debt has also fragilized the world’s economy. Leveraging investment might be fine as long as the debt can be paid off, but the unexpected event can make that impossible.
Optimization of production lines, just-in-time production and the globalization of production and ever larger scales of mass production can lead to cost savings, but they also make corporations more fragile and vulnerable to unpredictable events such as the volcano in Iceland.
Nature and evolution, Taleb points out, have already taken into account the likelihood of the unexpected catastrophic event taking place. Humans have two kidneys because a backup may be needed in case one fails. “Economists,” Taleb said,”want you to have one kidney. Nature believes in redundancy. It is costly, but it is very good for survival. If you follow the security analysts and their economic theories, they will drive you to bankruptcy through optimization.”
Globalization and global communications, and specifically the internet, have accelerated the process of fragilization. Taleb points out that scientists have long observed that islands tend to have more biological diversity than continents. The reason is that the unhindered access offered by a continent encourages winner-takes-all domination by a few species. The same thing is true in a globalized economy. How does a steel company in France compete with a gargantuan competitor in China?
Taleb advises looking for niche markets where added value counts and the bigger competitors can’t be bothered to interfere. “Globalization is based on specialization,” Taleb warned,”but if the market for your specialization disappears, you are dead.”
The bottom line to all this, Taleb says, is to reduce vulnerability where possible and to emphasize robustness, while always keeping a fall back plan handy. As Taleb sees it, small tends to be robust, while being large can often increase fragility. Taleb’s advice: Put risk management at the center of your business, because what is fragile will ultimately break.
Finally, Taleb suggests that the older generation also has something to offer. A herd of elephants, he notes, respects the older elephants in the group. “The older elephants don’t teach,” he said. “They are the ones who say, ‘no.’ You invest the elders with the power to say, ‘no.’ Negative advice can be vastly more powerful than positive advice. People often don’t understand the value of survival. Simply not blowing up, can make you rich. Especially when others are becoming poor.”