Thursday, June 5, 2008

Black Swan

“Black Swan” is a book written by Nassim Nicholas Taleb. The central thesis of the book is the inability of the human mind to either visualise or predict event which have great impact on markets and life in general. The “unknown unknown” as he puts it differently from the “known unknown”. The outliers which exist beyond the six sigma bell curve. Ex 9/11 bombing, Oil at $135, Subprime etc

I will not dwell too much into the contents of the book as there is good summary available on Wikipedia. No point rehashing the same thing or doing cut paste :-) to increase content on my blog.

I will move forward to how do I factor in Black Swans in my investing process. The starting point is to acknowledge that black swans exist and the futility of trying to predict 10-15-20 years ahead.

In our investing lives we encounter both black and white swans ( positive ones). These are random in nature, however we tend to more often than not rationalise the white swans as a proof of our vision and insight and not attribute it to the roll of the dice.

Assuming that we encounter black and white swans in a equal probability of 50:50. The investment strategy should be that on a black swan the portfolio loses less than what the portfolio can gain on a white swan, hence on a net off basis remain ahead of the game.

To achieve this we come back to the original Benjamin Graham principle “Margin of Safety” in what we buy. If the portfolio has adequate margin of safety to ride out the black swans then any white swan will result in the portfolio outperforming the market.

PS: I like the cover of the book :-).


Mahendra Naik said...

Hi Ninad,
I have read Fooled by Randomness an earlier book by the same author and was impressed by it. I wonder if the author has anything new to say in Black Swan or is he simply rehashing the stuff. He has introduced in concept of Black Swan in the earlier book.

Ninad Kunder said...

Hi Mahendra

I m actually going the other way around by planning to read " Fooled by randomness" this week. Will be in a better positon to comment once I m done with it.