In the knowledge @ Warton series, Richard Herring interviews Nassim Taleb.
This is worth paying attention to, if only for the discussion on anti-fragility, which is the subjects of Taleb's new book Antifragile: Things That Gain from Disorder.
People talk about black swans but they don't talk about robustness to black swans.
Herring: Yes, that is very much in line with your contribution to our recent book, The Known, the Unknown, and the Unknowable in Financial Risk Management.
Taleb: The map into this terrain is quite difficult to follow. You have to avoid having things fail too late. You have to avoid debt because debt makes the system more fragile. You have to increase redundancies in some spaces. You have to avoid optimization. That is quite critical for someone who is doing finance to understand because it goes counter to everything you learn in portfolio theory. … I have always been very skeptical of any form of optimization. In the black swan world, optimization isn't possible. The best you can achieve is a reduction in fragility and greater robustness. You may have heuristics, but not an optimization rule. I hope the message will finally get across because I haven't succeeded yet. People talk about black swans but they don't talk about robustness, which is the real lesson of the black swans.
Herring: I would agree that you have raised interest in the phenomenon of black swans and certainly the emphasis on looking for them. But it is a very tough problem to know what to do. … We have to go to the next level of raising it, and really starting to identify what is vulnerable and what is not. Like we know that solar energy is not vulnerable to black swans, but nuclear — as we have just discovered — is found with the black swans. The one in a million year accident has happened…
We seem to have had over the last six weeks a number of black swans flying through our global universe. You know a lot about the Middle East. Should the “Arab Spring” of political revolutions in the Middle East and North Africa be considered a black swan?
Taleb: The events in the Middle East are not black swans. They were predictable to those who know the region well. At most, they were gray swans or perhaps white swans. One of the lessons of “Wild vs. Mild Randomness,” my chapter with Benoit Mandelbrot in your book, is what happens before you go into a period of wild randomness. You will find a long quiet period that is punctuated with absolute total turmoil. … In The Black Swan, I discussed Saudi Arabia as a prime case of the calm before the storm and the Great Moderation [the perceived end of economic volatility due to the creation of 20th century banking laws] in the same breath. I was comparing Italy with Saudi Arabia. Italy is an example of mild randomness in comparison with Saudi Arabia and Syria, which are examples of wild randomness. Italy has had 60 changes in regime in the post-war era, but they are inconsequential…. It is a prime example of noise. It's very Italian and so it's elegant noise, but it's noise nonetheless. In contrast, Saudi Arabia and Syria have had the same regime in place for 40 some years. You may think it is stability, but it's not. Once you remove the lid, the thing explodes.
The same kind of thing happens in finance. Take the portfolio of banks. The environment seemed very placid — the Great Moderation — and then the thing explodes.