By Nassim Nicholas Taleb
In 2003 Nassim Nicholas Taleb made a fascinating presentation to the Highlands Forum in our meeting on Risk in a Networked Environment. His best selling book at the time, Fooled by Randomness, was the stepping off point for his talk at the Bellagio Hotel, a talk he cheekily titled "Gambling With the Wrong Dice". Taleb told us: "When we don't know how much we don't know, no mathematics will ever yield a meaningful answer. Power laws and the law of large numbers don't work when we have fat tails. Alternatively, but no less viciously, the tail may settle, but too slowly to run the law of large numbers. We refer to this as the 'fourth moment' – i.e., the variance of the variance – which is how much we don't know what we don't know. I have been studying this since 1987, and I don't believe that anyone knows anything about the incidence of rare events. Nothing works". He referred to Black Swan events, highly improbable occurrences that are unpredictable, carry a massive impact, and in hindsight we rationalize an explanation that makes it appear less random than it was. In that same Highlands session he presciently spoke of the danger of networked and tightly couple financial systems: "The idea of using networks is dangerous in finance. Networks have the ability to explode – they are scale-free, meaning that there is no upper limit on how much can be centered on one node, and the probabilities of hitting that node go up dramatically. This causes clustering. So the whole system can go down at once, together. Several years ago, once piece could have gone down and the others would have been unaffected. LTCM went down in 1998 and brought down several other hedge funds with it. But that was easy to address. The Federal Government intervened to make sure it didn't happen again, that there weren't more funds out there like LTCM. The problem in the financial world is that you are dealing with aggregates. In finance, things are much more interrelated than they would be elsewhere. If Citibank is bankrupt, other banks don't collect money. If Google goes down, on the other hand, we can go around it. The contagion effects of networks are a critical issue – everyone ends up doing the same thing because of information cascades. This is a real problem". Now follows Taleb’s best work, his new book titled The Black Swan: The Impact of the Highly Improbable, which aggregates with examples his thinking on this topic to date. Taleb writes clearly that the bell curve does not explain the events we have to deal with, but rather the power law (further explicated by Highlands presenters Clay Shirky—his forthcoming book is Here Comes Everybody: The Power Of Organizing Without Organizations—and Chris Anderson, author of The Long Tail) is where we need to search. His message for investors and for DoD alike is to "Look for ways to foster serendipitous developments while preparing broadly for disaster". Highly recommended.