As a simple example (the general argument applies to all sectors and all forms of risk), consider a bank ("safe bank") keeping $X in reserve to handle unforeseen events. Another bank ("risky bank") which keeps only $X/2 in reserve.
Risky bank will have a advantage over safe bank at all times except when an event requiring between $X/2 and $X occurs. Should such a rare event occur, risky bank would fail and safe bank survive.
Once the frequencies of such events drop to low enough levels (once ever 5? 10? 20? 40? years), there is no market pressure on the riskier bank to plan for the problem (and in fact the opposite, the market will destroy safe bank).
The actual time period is I think determined by how long it takes risky bank to out-compete safe bank and so drive it from the market as a significant force.
1. There is not much in the way of market pressure in the "Great Moderation" banking system (weak regulation, deposit guarantees) to drive out risky banks - they are a net gain for investors (ignoring the agency effect of bankers screwing their shareholders through bonuses), since bank failures represent a form of subsidy to the financial system. Some shareholders get some of the stock wiped out, but it is all limited liability; others profit magnificently.
2. The libertarian banking system that we saw in C19th (little regulation, no systematic deposit guarantees) does seem to have the right market pressure, but it seems to be yet more unstable since we saw it face regular bank runs followed by grand-scale financial collapse - the 19th century was more economically unstable than the 20th century for this reason, with the UK (then dominant in finance) having 5 major financial crises; one of which (the 1873 panic) led to a depression lasting 2 years longer than the Great Depression. So your frequency's "low enough levels" seems to be around every 20 to 25 years.
3. So deposit guarantees of institutions in exchange for effective regulation that avoids the dangerous effects of excessive leverage, so outlawing your risky bank, seems to be the way forward. Unfortunately it is in the interests of these financial institutions to subvert regulation, so designing such regulation is hard ("who could have forseen that the banks accounts could have mispriced risky assets and moved gigantic liabilities off balance sheet yet again?")
This isn't really a Black Swan issue, it's an agency issue where neither depositors nor regulators understand what banks are doing. But Black Swans do tend to crowd around important, hard to figure out areas of endeavour.
https://news.ycombinator.com/item?id=4942341
I think it is exactly a black swan issue. The markets punish companies which do not compete sufficiently effectively.
Companies which plan for low-probability events are less effective in the medium term than companies which don't.
You seem to assume that all risk is meant to be carried by the banks. As you note, such a thing is possible (up to the risk-bearing capacity of any given bank), but such banks would be very expensive. Consequently, most customers bank with riskier institutions and this places more of the risk back onto them.
So, in actual fact, this is the market doing what it does pretty well: solving a hyper-distributed problem with heterogenous agents with numerous complex, incompatible preferences.
Sometimes we don't like the outcome. That doesn't mean that the market has "failed"; it just means that we don't like the outcome.
Even if we can't think of a better solution right now, we shouldn't stick our collective heads in the sand when we notice errors in our current approach. Highlighting errors is important, because even if we can't fix them right now, we may be able to in the future. If we don't know about the flaws in our current approach, it it impossible to even attempt to think of ways to improve them.
The problem is that any two competitors X and Y, in any field.
If X does not plan for low-probability failure and Y does, then Y will not have the additional inefficiency/overhead and so X will out-compete Y.
If the time frame for low-probability failure is long enough, and if being out-competed means the end of your business, then an efficient market means that risks which typically take longer than time T to manifest will not be handled, where T is the time for X to out-compete Y, given their advantage.
This isn't just a failing of an efficient market - it's a "failing" of any system with a time horizon.
Politics has similar incentives (election in 2012, who cares about 2013?), as does software development (who cares about code maintenance after I leave), management, etc.
In an 'efficient' market all future risk is included in the analysis of current value meaning that if it was an 'efficient' market this would actually not be a problem. However it is just one of many* ways that markets are not in reality 'efficient' in the economics sense as the assumptions required to prove them just do not match up to the real world.
* http://www.amazon.com/Debunking-Economics-Revised-Expanded-D...
The EMH claims that all future time discounted risk known to market participants is included in the analysis of current value.
If you want to show the markets are not efficient, go achieve excess risk-adjusted returns. The sole claim of the EMH is that you can't do that. The EMH doesn't claim that market participants will not take risks, nor does it claim that investors/customers will not apply time discounting to those risks.
Well, yes. The economists know that.
They are the perfect example of a Black Swan. Quote Taleb (Black Swan, p.xxii): "... in spite of its outlier status, human nature makes us concoct explanations for its occurence after the fact, making it explainable and predictable", which is exectly what she is doing. And, one page later on 9/11: "had the risk been easily conceivable on September 10, it would not have happened".
He is not advocating abandoning risk management, he is in favour of risk management that doesn't need us to predict the future, as it is harder to reliably estimate the likeliness of very unlikely events.
Concerning the second example of earthquake risk and nuclear power plants: That, again, is a post-hoc rationalization. Everybody knew that earthquakes were a risk factor for NPP and was planning accordingly. They were just not planning for a Tsunami this size, as it was very, very unlikely. So including higher error margins for earthquakes next time is nice but not enough. Taleb on this: http://www.valuewalk.com/2011/03/nassim-taleb-black-swans/
Consider the aviation industry: After an accident, they find the root cause and eliminate it. It is now something expected, and can be directly dealt with. But also try to improve the system (e.g. via training) to be more robust towards all the root causes the didn't anticipate.
I disagree.
The black swan is something that is completely unforeseeable and for which there are no previous partial or complete examples, either of the final outcome or the contributing causes.
Which is her point: 9/11 was foreseeable from the information (the failure was in connecting it) and the fact that a previous, similar plot had been tried in France. The clues were there and there was a previous partial example.
1. The event is a surprise (to the observer). 2. The event has a major effect. 3. After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected; that is, the relevant data were available but unaccounted for in risk mitigation programs. The same is true for the personal perception by individuals.
Thanksgiving is a black swan for the turkey but not for the butcher. Taleb is trying to solve the problem of how not to be a turkey, and prediction is insufficient for that problem, because errors of prediction will let the worst events through anyway. Rather one should evaluate how much worse things will be as an event grows. If problems grow faster than linearly, trouble will strike eventually.
Not according to Taleb, who should know as he developed and named the concept. According to him a black swan only has to be unpredictable to the observer.
But the point is that ignoring the possibility of unpredictable (to you) events is a fallacy. So a black swan event is any event an observer assumes is impossible, or so unlikely as to be ignorable, but then actually happens. Whether an event is a black swan, being an observational fallacy, is subjective.
So taking the 9/11 attacks, for some professionals in the intelligence agencies these were not black swan events because they knew they could happen, but for the population at large and to politicians in particular, they very much were black swan events.
There is no such thing as something completely, entirely 100% unforeseen or unforeseeable. Someone, somewhere in the world will be seeing it coming... just as some intelligence analysts saw 9-11 coming, some economists saw the financial crisis, etc. etc. What we're considering is what the prevailing and strongly established consensus well outside the fringe areas says.
As far as someone is concerned. You misunderstand what a Black Swan event is. A Black Swan is at the root an opacity problem, and not one of forecasting. 9/11 certainly wasn't a Black Swan event for the hijackers or the masterminds, but it was for everyone else.
Otherwise they would not be black swans, they would more be like the whale falling out of the sky in the Hitchhikers Guide To the Galaxy, that has formed spontaneously out of random particles.
http://www.amazon.com/Thinking-Fast-Slow-Daniel-Kahneman/dp/...
"Traditional financial analysis, she said, is based on evaluating existing statistical data about past events. In her view, analysts can better anticipate market failures – like the financial crisis that began in 2008 – by recognizing precursors and warning signs, and factoring them into a systemic probabilistic analysis."
So, let's say you do provide a systemic probabilistic analysis about the impending education crisis the US is about hit? Don't you think a government would be gnawing their hands off to get that type of statistical analysis? Personally, I don't think it systematically exists.
You have an elephant in the room. After it explodes, everyone will say it was a black swan.
Is a really good geopolitical paper I recently read about black swan stuff. The general gist, to my understanding, is that artificially supporting a regime makes it weaker.
http://www.amazon.com/Antifragile-Things-That-Gain-Disorder/...
It is an enjoyable read so far...
