I want to share a personal anecdote from yesterday. While hiking in Muir Woods, I witnessed a man trip and tumble down a steep hill. Thankfully, he was alright—miraculously so! There were plenty of people around who quickly came to his aid.
This unexpected incident brought to mind a concept that is highly relevant in finance: the Black Swan, popularized by Nassim Nicholas Taleb in his impactful book.
Let’s explore what you need to know about the Black Swan phenomenon!
What Is a Black Swan?
First, let’s start with a bit of history. Centuries ago, Europeans believed that black swans did not exist—until Dutch explorers in Australia discovered them in 1697.
This serves as a valuable illustration: people often think something is impossible until it actually happens.
Nassim Taleb appropriated this metaphor and applied it to unexpected and impactful events in our lives and economies. He summarizes a Black Swan event with the following attributes:
- Outlier Status: It lies outside the realm of regular expectations, as nothing in the past can convincingly predict its occurrence.
- Extreme Impact: These events have far-reaching effects.
- Post-Hoc Explanations: After a Black Swan event occurs, people will concoct explanations to make it seem predictable, even though they couldn’t foresee it beforehand.
A recent example of a Black Swan event is Donald Trump’s election victory. Before he won, few believed he had a reasonable chance (many predicted as low as 4%!). His win shocked many, yet afterward, people pretended they “always knew” he might succeed, offering various theories about why he did.
As illustrated, it’s crucial to note that the perception of these events can vary based on perspective. For example, the 9/11 attacks were a Black Swan event for the victims but not for the perpetrators. Similarly, Thanksgiving is a Black Swan moment for turkeys but not for those preparing the meal.
Mediocristan vs. Extremistan: Where Do Black Swans Live?
One of the most valuable frameworks from Nassim’s work is the distinction between Mediocristan and Extremistan.
- Mediocristan: This is where outcomes are predictable, and events follow a consistent pattern. If you hold a typical job and have a steady income, no singular event will dramatically change your wealth overnight; long-term financial stability comes through saving and investing.
- Extremistan: On the opposite side, this is characterized by extreme volatility, where outcomes can swing wildly from good to bad. Investing in highly speculative assets, like Bitcoin, can yield substantial gains or lead to significant losses in a very short time.
Ideally, you want to balance your investments between both worlds—keeping most of your wealth in Mediocristan and a smaller portion in Extremistan.
The rationale? Many of life’s most transformational moments arise from Extremistan, but those moments can’t be planned.
Consider how Columbus stumbled upon America while seeking a shorter route to India or how scientists accidentally created Viagra. Great breakthroughs often happen by chance in Extremistan.
Preparing for a Black Swan
Now, here’s the important part: Preparing for a Black Swan doesn’t mean you can predict one.
It’s best to avoid attempts to foresee which events might occur. As Taleb cautions, “Do not try to predict precise Black Swans; it makes you more vulnerable to those you didn’t foresee.”
Beware of “Pascal’s Scams”
The term “Pascal’s Scams” comes from the philosopher Blaise Pascal, who argued that under uncertainty, many tend to overemphasize improbable scenarios. This can lead to excessive worry over events that might never materialize.
Nick Szabo articulates this concept, warning us that when assessing various doomsday scenarios (like asteroid impacts or economic collapse), it’s difficult to accurately gauge risk and consequence.
Instead of fixating on unlikely scenarios, focus on practical insights that can be drawn from real-world experiences.
Be “Black-Swan-Robust”
While you cannot be entirely “Black-Swan-Proof,” you can adopt a “Black-Swan-Robust” mindset.
This means instead of preparing for specific Black Swan events, ensure that you have strategies in place to weather any unexpected disasters. Here are some ways to thrive regardless of economic upheaval:
- Avoid Debt: Stay financially unencumbered to handle any financial setbacks.
- Embrace Minimalism: The less you own, the less you risk losing. If your possessions fit within a manageable framework, you can easily recover from setbacks.
- Live Frugally: Learn to make ends meet with the least expenditure possible.
- Diversify Your Investments: This reduces the impact of any single investment failing.
- Adopt a Long-Term Perspective: Wealth accumulation and financial security should be viewed over decades, not days. Understanding historical market behaviors will prepare you for the future.
- Develop Multiple Income Streams: Having various revenue sources can safeguard against economic downturns.
By applying these strategies, you’ll not only protect yourself from the unpredictability of Black Swans but also enhance your resilience.
Final Note: Enjoy Life
While the prospect of unforeseen events can be daunting, don’t let it paralyze you with fear.
Avoid letting worries about catastrophic scenarios dictate your financial decisions. Each dollar spent preparing for improbable disasters could be better invested in your future.
As Taleb reminds us, “Consider the odds of your existence to the great wonders of the universe, and focus on what truly matters.”
Thank you for engaging in today’s discussion, and I look forward to our next exploration together!
Let me know if you need any adjustments or additional information!