Comments: When catastrophe strikes, blame a black swan

I saw a review on the Guardian online and this section really stood out;

Taleb is a fan of the Polish-born French mathematician Benoit Mandelbrot, who gives short shrift to those who believe financial markets resemble a bell curve, with modest movements the norm and violent moves infinitesimally rare. Looking at the daily movements of the DJIA from 1916 to 2003, Mandelbrot said that according to the neat bell curve analysis, there should have been 58 days when the Dow moved more than 3.4%, when in fact there were 1,001.

Instead of just six days when there were movements of more than 4.5% there were 366. Only once in every 300,000 years should there have been a day when the Dow moved by 7% or more, but it happened 48 times. "Extreme price swings are the norm in financial markets - not aberrations that can be ignored. Price movements do not follow the well-mannered bell curve assumed by modern finance; they follow a more violent curve that makes an investor's ride much bumpier," Mandelbrot says in his book The (Mis)Behaviour of Markets (Profile Books). "A sound trading strategy would build this cold, hard fact into its foundations".

The argument that markets are efficient to a certain extent relies on them to be rational and the phenomenon that Mandelbrot was intrigued by gives some pause for thought about just how rational markets are.

I'm not sure that I'd agree that markets are necessarily efficient or rational; perhaps 'less inefficient than the alternatives' and 'mostly rational' in the same way as The Hitch Hikers Guid to the Galaxy describes Earth as 'mostly harmless'.

Posted by Jonathan at May 6, 2007 12:57 PM

Taleb isn't saying we shouldn't predict, he's saying we should know the limitations of our predictions. For global warming the models will predict modest increases in temperature, there are scenarios however where feedback loops could drive extreme temperature changes that exterminate all life on earth.

We can't predict how likely that is, because our models will never be accurate enough and because we're straying into long tail, black swan unpredictability. So the best case is warming, the worst case is total annihilation.

This means there is no downside to acting now. Best case we avert the crisis, worst case we reduce the impact.

In fact there is considerable upside, because if there is a positive 'black swan' - a positive but unpredictable event - then we've reduced our reliance on fossil fuels, headed off peak oil and given ourselves cleaner air and lower impact on the environment. Bonus!

It's not about whether or not we can predict, it's about investing to protect against downside risk, while maximising upside risk.

Posted by Nick Jenkins at May 20, 2011 04:39 AM
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