TIP047-the-black-swan

Executive Summary

 

This article provides an overview of Preston, Stig, and Hari’s discussion of “The Black Swan” by Nassim Taleb. This is a book that has been named one of the twelve most influential books since World War II by the Sunday Times and is one of billionaire Jeff Bezos’s favorite books. If you want to read our executive summary of, The Black Swan, view this page instead. If you would like to download all of our book summaries, click here.
This article and podcast answers the following questions:

  • Who is Nassim Taleb and what is a Black Swan?
  • What are Mediocristan and Extremistan?
  • sk The Investors: Is Mark Cuban right when he says that value investing is only for the big guys?

Who is Nassim Taleb and what is a Black Swan?

Nassim Taleb has an untraditional background. He’s been very successful as a hedge fund manager and derivatives trader, but is now a professor at the New York University School of Engineering. Taleb explains the concept of his book using a black swan as a metaphor. Everyone thinks that all swans are white because the swans they have seen so far have all been white; however, a black swan turns up eventually. You can’t predict when it will happen, and you can’t predict what will happen when it does.

What are Mediocristan and Extremistan?

The premise for Taleb’s view on the world is that we both live in Mediocristan and Extremistan; however, most people think we only live in Mediocristan, which eventually turns out to be catastrophic. As an example, consider the human height. The average for males in the US is 5’9 with fewer males at 5’6 and even fewer that are 5’3. The same can be said about males with a height of 6’0 and 6’3. Academics call this a “normal distribution”. When something like height is normally distributed, it means that you can reasonably predict how many males are between 5’3 and 6’2 if you walk into a room with 100 people.

So what is Taleb’s objection to this? Well, he is arguing that we should always consider if the factor we examine is in Extremistan or on Mediocristan – like height. He mentions net worth as an example. In the US, the median net worth is $45K, which means that if you have 300M Americans and lined them up from Bill Gates at the top to a homeless person at the bottom, then the 150Mth person would have a net worth of $45K. Contrarily to height, when it comes to net worth, the median is very different than the average. The average is $301K. Now try to walk into a room and predict the median and average net worth – it’s suddenly much more complex.

This is really the essence of The Black Swan. If we, as humans, are confident that we only live in Mediocristan and don’t take the precautions of living in Extremistan, we are heading for trouble. Taleb mentions the stock market as an example. Many professional risk managers have, and are still making the mistake of believing that we can predict stock returns according to a normal distribution. Their models are built in such a way that in order to manage risk, we have to assume that we can rely on the past, and that a crash is highly unlikely. Since the stock market exists in Extremistan, the repercussions of relying on the normal distribution are at best irrelevant and at worst catastrophic. Specifically, he mentions the hedge fund Amaranth that lost $7B of its investors’ money though they were equipped with 12 risk managers. According to Taleb, it wouldn’t matter if they even had 100, since the problem lay in the managers’ perception of the world. They didn’t know they lived in Extremistan.

Ask The Investors:Is Mark Cuban right when he says that value investing is only for the big guys?

The investors don’t agree with Mark Cuban. On the contrary, it’s a huge advantage to have little capital if you want to have high returns. Value investing is all about finding securities that are priced cheaper than the intrinsic value. Investors like Warren Buffett find it tough to source undervalued listed stocks as he has accumulated more capital. The market cap of Berkshire Hathaway is more than $300B. That means that if Buffett invests $1B in IBM, he will not only be hoping to get a good return of less than 0.3% of his market cap, but he would also move the stock price, which will diminish his expected return. When Buffett was handling only thousands of dollars and not billions, he had a track record of more than 50% in annual return. That’s simply impossible to do with the amount of capital he has today.

Books and resources mentioned in this episode

Nassim Taleb’s book, The Black Swan – Read reviews of this book.

Robert Cialdini’s book, Influence – Read reviews of this book.

Morgan Downey’s book, Oil 101 – Read reviews of this book.

Hari Ramachandra’s Blog, BitsBusiness.com

Videos that Support this Podcast

Financial Collapse: A Panel with Nassim N. Taleb & Robert Shiller


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