The ‘black swan’ problem was first posed by the Scot philosopher David Hume and deals with the danger of making universal assumptions based on empirical reasoning. A man sees one white swan, then another, then a third, and so on. So he comes to the conclusion that all swans are white, an bases a universal theory on this premise. Then along comes a single black swan and the grand theory comes crashing down like a pack of cards.
Nassim Nicholas Taleb – a successful Wall Street stock trader, a professor of mathematics and statistical science, and author of international iconoclastic bestsellers like Fooled by Randomness and The Black Swan, both of which demolish myths regarding ‘experts’ who advise people on stock investments – has taken Hume’s concept and made it the basis of a brilliant critique of those who predict the market’s future behavior from past performance and claim to discern ‘trends’ in what Taleb insists is pure chance. In short, those who allow themselves to be ‘fooled by randomness’ frequently bankrupt themselves and others.
An extension of the ‘black swan’ proposition (seeing 50, or 100, white swans is no guarantee that the next swan you encounter won’t be a black one), is the ‘heads or tails’ misconception. Just because a tossed coin has turned up, say, heads 10, or 20, times in a row, this doesn’t to any extent statistically increase the chance of it turning up tails on the 11th, or 21st, throw. A coin has no ‘memory’; it is we who project the coin’s future behavior by looking at the past. Similarly, markets don’t have a collective ‘memory’ on which future prognostications can be made. In Taleb’s view, the only 100 per cent certitude is that there are no certitudes; unpredictability is the only predictability.
Does this mean that all market investments are a pure gamble, sheer luck, good or bad? Certainly not. Taleb has himself very profitably played the markets for over 20 years. His advice? Gather as much publicly available information as you can about an investment before making it. Feed the information into a ‘Monte Carlo machine’ – a complex mathematical model based on the design of an imagined roulette wheel – which will give you the probability (not certainty) of the success of your investment. Never follow so-called ‘hot-tips’ which turn out to be ticking time bombs. Never, ever, invest more than you can afford to lose without ‘blowing up’, i.e. going bankrupt. And always be wary of the black swan waiting around the corner.