Before the discovery of Australia, people in the Old World were convinced that all swans were white, an unassailable belief as it seemed completely confirmed by empirical evidence. The sighting of the first black swan might have been an interesting surprise for a few ornithologists (and others extremely concerned with the coloring of birds), but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single (and, I am told, quite ugly) black bird. — Nassim Taleb, The Black Swan: The Impact of the Highly Improbable
The earthquake, tsunami and current nuclear crisis in Japan, as well as the current geopolitical unrest in the Middle East challenge the concept of market stability. Black Swan events have tested the limits of the financial markets and banking systems for decades (some might recall the “Tulip Mania” bubble in the early 1600’s). Reflect on the following list, via Doug Kass of those once in a lifetime events that have occured over the past decade:
- the Sept. 11, 2001, attacks on the World Trade Center and Pentagon;
- a 75% decline in the Nasdaq;
- the 2003 European heat wave (40,000 deaths);
- the 2004 Tsunami in Sumatra, Indonesia (230,000 deaths);
- the 2005 Kashmir, Pakistan, earthquake (80,000 deaths)
- the 2008 Myanmar cyclone (140,000 deaths);
- the 2008 Sichuan, China, earthquake ( 68,000 deaths);
- financial derivatives roil the world’s banking system and financial markets;
- the failure of Lehman Brothers and the sale/liquidation of Bear Stearns;
- a 30% drop in U.S. home prices;
- the 2010 Port-Au-Prince, Haiti, earthquake (315,000 deaths);
- the 2010 Russian heat wave (56,000 deaths);
- BP’s Gulf of Mexico oil spill;
- the 2010 market flash crash (a 1,000-point drop in the DJIA);
- the broadening scale of unrest in the Middle East; and
- Thursday’s earthquake and tsunami in Japan.
Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks — when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crises less likely, but when they happen, they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur … I shiver at the thought. –Taleb
In Nassim Taleb’s words, It is often said that ‘is wise he who can see things coming.’ Perhaps the wise one is the one who knows that he cannot see things far away.