Black Swans and human relations

Last week, I travelled to Zurich for a conference on hedge funds. I'd never been to a conference on hedge funds before, and only went this year because I'd read so many juicy stories about the spectacular collapse of the hedge fund market, that I wanted to go over and gloat at the humbled titans of global finance and see what they were planning to do now. Rubber-neck journalism of the lowest kind, in other words.

The conference was at the Dolder Grand, a salubrious, airy hotel perched on a hill above the town, with a fine view of the snowy Alps that circle the town like so many bodyguards, to shield it from the prying eyes of any tax inspectors. Inside the mountain retreat, the mood was sombre. The hedgies gathered, like characters in a Thomas Mann story, to try and cure themselves of the incurable ailment of the credit crunch.

I too was in a bad mood. I didn't really care about the demise of the hedge fund industry, or even about the possible collapse of western capitalism. I was brooding over the fact a friend of mine hadn't invited me to their birthday party. I was taking it very un-Stoically, wondering what I had done to deserve this slight, and whether it presaged an inevitable failure on my part to assimilate socially. I had reacted rather over-sensitively, as my post-traumatic personality tends to do.

We watched in numbed silence, the hedgies and I, as panel after panel spoke in hushed tones about the possible extinction of their industry. And then a gentleman called Nassim Nicholas Taleb took to the podium, and everyone perked up.

Taleb is a former banker, with 20 years' experience as an options trader, and is also the author of two very successful books - Fooled By Randomness: The Hidden Role of Chance in Life and in the Markets (2001), and more recently, of The Black Swan: The Impact of the Highly Improbable (2007).

His key idea is this: markets use statistical models, such as the Sharpe ratio or Value At Risk (VAR), to try and predict the likelihood of things happening, and thus to manage risk. But these models are all useless.

They are useless because they only predict the future based on the average returns of the past. However, markets are often affected by what he called 'Black Swan events' - abrupt and improbable events, which nevertheless have an enormous impact on the market.

He says: "Take any class of random observables in the market, and the exception dominates, not the mean. Take publishing. Out of the 16,000 novels published each year, the vast majority of the revenue will be made by between five and 35 books. Take software companies - out of 50,000 companies, more than half of sales are accounted for by one company, Microsoft. The exception dominates."

It is the same in financial markets. It is no use trying to predict what will happen by looking at the average performance over a period of time. A Black Swan event can occur at any time, and render your risk model completely useless. Taleb used to trade options for UBS and BNP Paribas. He says: "If you look at UK interest rate options from 2008 to 1988, 99% of the variation during that period was in one day, September 16 1992, when the UK left the ERM."

Taleb has a dim view of modern banking risk management, which tries to predict the future by the average events of the past. He mocks former Fed Reserve chairman Alan Greenspan for saying 'this has never happened before': "What large-scale event ever had a precedent? No financial crisis ever had a precedent, just as no war ever had a precedent."

Western banking, for all its sophisticated quant models and rocket scientist analysts, has repeatedly lost everything it ever made in one catastrophic quarter. It happened in 1982, and again in 1987, it almost happened in 1998, and now has happened again in 2008. In 1982, when Citicorp had to be bailed out by the American government, the then-chairman Walter Riston, said 'It was just a bad quarter'. Taleb said: "What do you mean, a bad quarter, when you lost all the money you ever made? That's like owning an airplane, and saying 'well, it only crashed once'."

The conclusion to be drawn from Taleb's insights is that we know less than we think we know. We are more in the dark than modern risk management pretends. Bad things happen, and they are very hard to predict. However, good things can also happen, equally hard to predict. We exist in a cloud of unknowing, and should humbly accept that fact. "I am trying to make my life as simple as possible", Taleb says. That is the best possible defense against Black Swan events.

Taleb acknowledges that his intellectual ancestry is an ancient Greek sect called the Sceptics. The sect was started in the late fourth century BC by a Greek philosopher called Pyrrho, and developed in the second century by Carneades.

The Sceptics were a rival school to the Stoics, whom they contemptuously called the Dogmatists. This is because the Stoics claimed one could 'know' the world, recognize its divine structure, and order one's soul accordingly.

This was dogmatic and foolish, the Sceptics responded. We can never 'know' whether something is true or not, we can only say that it appears so to us. This applies to predicting what will happen, or why something else happened: we can never second-guess the universe. Just because some things happened in the past, that doesn't mean something else will happen in the future. We are in the dark.

But this is not necessarily a bad thing, the Sceptics asserted. In fact, if we suspend judgments about things, if we don't cling to our opinions about the world, we can avoid unnecessary anxiety and attain a state of ataraxia, or tranquility. So in fact, even though their beliefs were very different to Stoicism, the aim of their philosophy was the same - a life free of worry.

On my way back to Zurich airport, I looked out on the fields of snow, and thought about Black Swan events. I'd read that month that German scientists had discovered a black hole at the centre of our galaxy. How long before some really big Black Swan hit the planet, and life on earth ended, just as improbably as it began?

My Blackberry vibrated in my pocket, like a small pet mouse trying to console me. I took it out and looked at it. It was an email from my friend, inviting me to a poker game. I wondered why he had invited me to that, and yet failed to invite me to his birthday party. And then I realised, he had probably sent my invite to the wrong email address. He often sent emails to an address that I no longer used. Or perhaps he had simply forgotten to invite me.

The point is, I didn't know. It could have been a number of different reasons, but my mind had seized on the most negative explanation - that he didn't like me, and that this signified my inevitable exclusion from society.

Again and again, my mind has betrayed this particular skewed bias. Several times, I have dug myself into a ditch of emotional abjectivity, because of my dogmatic interpretation of a particular event, and in fact, subsequent events have proved my initial interpretation to be far too negative and pessimistic. Yet somehow, I forget, and something else happens, that my mind seizes on as evidence to back up its pessimistic view of the world.

I am not alone in this. People with depression and anxiety disorders will very often jump to the most pessimistic explanations of random events. Someone gives them a dirty look in the street, and they interpret it as revealing some inherent weakness or flaw in their own personality, rather than wondering if that someone was simply having a bad day. They are dogmatic in their interpretation of reality. They cling to it, even on minimal evidence, even when their dogmatism is the cause of emotional suffering.

Scepticism can still play a role, then, both in trying to predict the global financial markets, and in trying to negotiate everyday human relations. We can never know exactly what others think of us, or why someone reacted as they did.

We can certainly try and discover the truth, we can communicate with others, ask them what they meant when they said such-and-such.

But we can also learn to keep an open mind, not jump to conclusions too quickly, learn to watch out for the skewed biases of our brains, be they either too optimistic or too pessimistic, and always to be prepared for the arrival of fresh data.