BLACK SWANS

In the Old World, all swans were thought to be white. Indeed, it was considered to be a fact, as empirically confirmed. No European had ever seen anything but a white swan.

Explorers to Australia found black swans. One sighting was all it took to discredit all of the evidence that came before. This illustrates the shortcomings of learning by trial and observation and of  inductive reasoning: the empirical evidence we use to reach conclusions and to forecast the future may be precisely wrong, especially in such a fast-paced world as the 21st century is proving to be.

Most commonly, we assume that tomorrow will be a continuation of today. Econometric models to forecast interest rates, GDP, unemployment, and the like, give the impression that they are scientific. High powered computers are only as good as the data they process and the assumptions in the underlying mathematical model. If the assumptions are wrong—notably that the future is an extrapolation of the recent past—the output will be worthless. The Long-Term Capital Management hedge fund crashed in the late 1990s, in spite of the fact that two of its board members were mathematical whizzes and Nobel laureates in economic sciences. The model on which the hedge fund was built was faulty under extreme and unusual conditions.

A parable is used to demonstrate the danger of using the past to predict. A turkey is born on a farm in the United States into relative comfort and is fed, watered, and cared for daily. He is pampered, by the standard for turkeys. Day-after-day and month-after-month, the caretaking routine continues…until a day arrives, shortly before Thanksgiving, when he meets the executioner. For the turkey, this is a black-swan event, a fatal unknown seemingly coming out of nowhere to rudely overturn the comfortable assumptions of the past.

Nassim Nicholas Taleb is a former mathematical trader on Wall Street. His bestselling book is titled The Black Swan. On Wall Street, black swans can and do occur and wreak havoc. On a single day, October 19, 1987, or Black Monday, the Dow Jones Industrial Average fell 22.6% and the S & P 500 declined by 20.4%. Black swans are evident elsewhere. On September 11, 2001, terrorists hijacked airplanes and leveled the World Trade Center buildings in New York and attacked the Pentagon in Virginia.

Taleb makes the critical point that we often focus too much on the wrong things and leave ourselves vulnerable to the consequences of black swans (unknowns) and gray swans (mostly unknowns) that can devastate. For example, he uses the example of casinos. The major risks incurred by casinos do not originate with the gambling that goes on within the confines of their brick and mortar buildings. Through the use of statistical probability techniques and by diversifying across different tables, casinos can control gambling-related risks. Moreover, casinos can control for big bettors –“whales”—by laying off their bets to other casinos. Further, casinos have elaborate surveillance systems to minimize their risks from cheating. It is outside the gambling where the big-time risks lurk that can ravage them. The Mirage lost an estimated $100 million when Roy of Siegfried and Roy fame was maimed by a tiger. Roy had reared the tiger and slept with him at times, so the past did not foretell that the future would turn out as it did. Consequently, the Mirage had no insurance. In other cases cited by Taleb, a disgruntled construction worker tried to dynamite a casino and casino owner Steve Wynn’s daughter was kidnapped and held for ransom.

In businesses of all kinds, the managers can insure for catastrophes like fire, theft,  liability, and the death of a key executive. However,  as with the casinos, a black swan or a gray swan can come along and be much worse than any of the insured-for possibilities. The tourism industry was devastated in the aftermath of September 11, 2001, and many banks literally ceased operations in the wake of the financial meltdown of 2008.

Nothing can be done to absolutely inoculate a company (or a person) against a black-swan event, because an actuary cannot quantify the likelihood of an unknown unknown. One way for investors to guard against total devastation is to use a “barbell strategy.” Put the portion of their portfolio that they absolutely cannot afford to lose into the safest assets they can find, perhaps U. S. Treasury securities. (Even here, however, a black swan like a U. S. default on debt owing to massive spending, titantic budget deficits, and devaluation of the dollar could take place, expecially if China opted out of buying U. S. paper.) This amount will vary with a person’s age and propensity for risk. Then, the remaining amount can be placed into risky assets with the potential for extremely high returns. The risks in the risky part of the portfolio are spread in the same manner that venture capitalists invest. Instead of sinking everything into one high-risk enterprise, invest in many, so that if 80% fail, the 20% that succeed will likely more than compensate. 

 Another way to cope with  black swans is to ask the question, “If a horrible and totally unexpected and destructive event were to occur, how would my business deal with it?” Since, by definition, a black swan is unknown, all you can do is assume the worst and that business would be virtually at a standstill. At the least, you can speculate on some gray swans and ask how your business would react.

I have sometimes  inquired of small-company manufacturing owners how they would respond if their place burned down. That is not even a black swan, because insurance companies can estimate its probability across all businesses. Most respond only by saying that they are insured. But how long would customers be without supply, that is a key issue? Would they seek alternative suppliers and perhaps never return? The majority of business owners are like the casino executives, who focus on the risks inside the walls of the firm, but who neglect to devote even a modicum of attention to how to contend with devastating unknowns, including their own sudden demise.

People sometimes say not to worry about what you cannot control. This is bad advice. You cannot control the future, but you can hedge your risks and plan for repercussions.

The racing industry is fraught with risks…with gray swans lurking everywhere, and maybe some black swans.

Copyright © 2010 Horse Racing Business

Comments

  1. I don’t know, Bill – it seems to me that for racing, the black swans are hiding in plain view. It’s more like the Emperor’s New Clothes. Everyone sees the problem, but no one will or can do anything about it. A terribly frustrating situation.

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