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This theory basically states that you cannot necessarily draw conclusions from historic events. In the specific case of swans European people thought that there are no black swans in this world just because people living in Europe only have seen white swans in the course of thousands of years. This assumption was falsified by the discovery of black swans in Australia by the end of the 17th century.
In the context of economics a black swan is a very rare event outside our expectations as it cannot be derived from historical data. Besides rarity Taleb adds extreme impact and retrospective explainability to the characteristics of a black swan event. He theorizes that a small amount of these types of black swan events determine everything in our lives and in history.
Black Swans can only be explained after the event, never before, as they are non-predictable and the large impact makes them important enough to influence the course of economic history, or in a wider sense your life, many people’s life or history in general.
Examples in economics of the failure of prediction based on past data would be the fall of Enron or any other demise of formerly large companies which everybody believed they’d stay forever. Just because those companies did very well the last decades, i.e. historical data, does not mean any company will not fail in the future, i.e. not existing predictability. Most people fall into the common fallacy that from the retrospective all bankruptcies or other economic events could have been explained before they occured.
To simplify it let’s take a look at investments: On the one hand there are all these so-called “blue chip” stocks. People believe they are “safe” as there is a long history of success of those companies of the Fortune 500 list. But most people fail to see that there is a limited upside to blue chips. The profits for companies like GM, GE or many others, you profit from them mostly in the one digit number. But the downside is zero, as in worthless, 0 US$, total loss. Therefore blue chips are actually are high risks if you are only invested in them because – contrary to common believe – they only offer limited upside (e.g. 8%) but an unlimited downside (total loss).
On the other side if you spread your investments to many small company stocks with a higher chance could fail, but which have an unlimited upside. Those are companies like Apple, Starbucks or Coca Cola in their start-up phase when they were not even listed. At a later stage they became a black swan among the thousand other companies, which were playing in the same time and field but failed.
As you never could predict which of the hundreds of computer makers, coffee shops or soda producers will make it by the end of the day you spread your investments on many potential winners. With this approach of course there is a downside – potentially hundreds of minor losses, but surely not all of them, some even make minor profits. But there is the unlimited upside for a black swan (much more than the usual 8% of blue chips) which covers all the small losses you surely made.
Following this strategy requires a resistance to our basic human psychology – that negative events have a higher impact on your emotional well-being then a good event.
At times when the tiger in the jungle was a threat to health and life, and therefore had a much stronger effect on the emotional system of the brain then enjoying a meal at the river, this psychological imbalance made sense for survival. But used on the modern society it is dangerous: It is emotionally easier to bear to win 100 times 1% and lose 1 time everything then to loose 100 times 1% and one time win 1000%.
If you calculate it, the latter wins economically.
The Black Swan Theory is a fascinating subject which can be applied on business and life, not only on investments and stock picking.
My profits from my businesses can be – of course also here in retrospect – explained (but not forecasted) by the black swan theory:
Testing a lot of business approaches / products at relatively low stakes and in the process making a lot of small losses until I get a “Black Swan”, i.e. a few winners which cover the many small losses accumulated in the recurring tests. Then if I get those winners I follow them up more intensively.
Contrary to stock investment where the black swan is manifested already in a high stock price and thus impeding a repetition of the same success, in business it is possible to reuse the discovered black swan.
As my black swan is not a stock already high in evaluation but a business approach or product within a business I can use the successful approach or sell the popular product again and again. Therefore, if applied to business, the black swan theory is even better than applied to stock investment!
It obviously works for me in my businesses and enables me to live an independent life relatively free from social and group dynamics. For me the “Black Swan Theory” is one more great theory successfully applied.