Black Swan Theory

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noun - Black swan theory or Theory of black swan events is a metaphor that encapsulates the concept that an event is a surprise (to the observer) and has a major impact. After the fact, the event is rationalized by hindsight.

Contents

Creator

The theory was developed by Nassim Nicholas Taleb to explain:

1. The disproportionate role of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology
2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)
3. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs

Background

Black swan events were introduced by Nassim Nicholas Taleb in his 2004 book Fooled By Randomness, which concerned financial events. His 2007 book (revised and completed in 2010), The Black Swan extended the metaphor to events outside of financial markets. Taleb regards almost all major scientific discoveries, historical events, and artistic accomplishments as "black swans" — undirected and unpredicted. He gives the rise of the Internet, the personal computer, World War I, and the September 11 attacks as examples of Black Swan Events.

When the phrase was coined, the black swan was presumed not to exist. The importance of the simile lies in its analogy to the fragility of any system of thought. A set of conclusions is potentially undone once any of its fundamental postulates is disproved. In this case, the observation of a single black swan would be the undoing of the phrase's underlying logic, as well as any reasoning that followed from that underlying logic.

Identification of a black swan event

1. The event is a surprise (to the observer).
2. The event has a major impact.
3. After its first recording, the event is rationalized by hindsight, as if it could have been expected (e.g., the relevant data were available but not accounted for).

Coping with black swan events

The main idea in Taleb's book is to not attempt to predict Black Swan Events, but to build robustness against negative ones that occur and be able to exploit positive ones. Taleb contends that banks and trading firms are very vulnerable to hazardous Black Swan Events and are exposed to losses beyond those predicted by their defective models. On the subject of business in particular, Taleb is highly critical of the widespread use of the Normal Distribution as the basis for calculating risk.

In the second edition of The Black Swan, Taleb provides "Ten Principles for a Black-Swan-Robust Society".

Taleb states that a Black Swan Event depends on the observer. For example, what may be a Black Swan surprise for a turkey is not a Black Swan surprise to its butcher; hence the objective should be to "avoid being the turkey" by identifying areas of vulnerability in order to "turn the Black Swans white".

Predictability of Unpredictability

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