Black swan theory stock market

Black swan theory stock market

Author: vovka On: 10.07.2017

The Impact of the Highly Improbable. Nassim Nicholas Taleb is having none of this. The effects of wars, market crashes, and radical technological innovations are magnified precisely because they confound our expectations of the universe as an orderly place. The Black Swan Theory is an event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict.

According to the prominent author, philosopher and NYU professor, Nassim Taleb, this type of event can be positive or negative, but deemed improbable, yet can cause massive consequences.

The disproportionate role of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology.

The non-computability of the probability of the consequential rare events using scientific methods owing to the very nature of small probabilities. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs. The event is a surprise to the observer. The event has a major impact. After its first recording, the event is rationalized by hindsight, as if it could have been expected e.

It is based on an Old World premise that black swans did not exist, because one was never seen until settlers ventured to Australia. Western Australia unofficial cygnis This video is about the Black Swan Theory, by Nassim Nicholas Taleb, where he explains the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations which no economist can predict.

He also states that any economist that says that they can predict the future is a fraud.

To watch this video click here. Unlike the earlier philosophical "black swan problem", the "Taleb theory" refers only to unexpected events of large magnitude and consequence and their dominant role in history.

Such events, considered extreme outliers, collectively play vastly larger roles than regular occurrences. Black swan events are typically random and unexpected. For example, the previously successful hedge fund Long Term Capital Management LTCM was driven into the ground as a result of the ripple effect caused by the Russian government's debt default.

The Russian government's default represents a typical event because none of LTCM's computer models could have predicted this event and its subsequent effects. Classic events, based on Taleb's theory, include the rise of the internet and personal computer, the September 11 attacks and World War I. However, there are many other events such as floods, droughts, epidemics and so on that are either improbable or unpredictable or both.

This "non-computability" of rare events is not compatible with scientific methods.

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The result, says Taleb, is that people develop a psychological bias and "collective blindness" to them. The very fact that such rare, but major events are by definition outliers, makes them dangerous.

black swan theory stock market

Other typical events include the Stock Market Crash, the Destruction of Pompeii following the eruption of Mt. Vesuvius in 79 A. D and the Atomic Bomb on Hiroshima in They include recent events such as the U.

Attacks on Sept 11th and the Japanese Tsunami on March 11, Black Swans are game-changers. They can also include unpredictable slower moving events such as the Collapse of the Roman Empire. Such events depend on which side you are on as to whether you are the recipient of a black swan event.

And now we have the latest game-changer — the European debacle! To some companies it had a devastating effect, and for options traders there was the opposite effect, if playing on the correct side of the track. The same was true for the momentous "flash crash" on May 5, which dropped points in 10 minutes resulting in catastrophic losses to some. Fortunes indeed could have been made by knowing in advance the last two events. Potential black swan events with potentially devastating effects are on the horizon.

But what is the probability that they will impact you, your company or your stock market investment? Is it even worthwhile to consider these types of events, let alone perform the calculations? Implications for Markets and Investing. Stock and other investment markets are affected substantially by all manner of events.

Downturns or market crash such as the dreadful Black Monday or the stock market crash of or the internet bubble of were relatively "model-able," but the September 11 attacks far less so.

The Black Swan (Taleb book) - Wikipedia

And who really expected Enron to implode? As for Bernie Madoff, one could argue either way. But the point is, we all want to know the future, but we can't. We can model and predict some things to an extent , but not others, not the black swan events.

And this creates psychological and practical problems. For example, even if we correctly predict some things that impact on the stock and other financial markets, such as election results and the price of oil, some other event like a natural disaster or war can override these other factors and throw our plans totally out of kilter.

Furthermore, events of this kind can happen any time and last for any length of time. Are the markets random or cyclical?

It depends on who you ask. There are risks and costs to a program of action.

But they are far less than inaction. To illustrate the unpredictability of these events, we'll look at past wars. On the one hand, there was the incredibly short Six Day War in , but on the other hand, in , people thought "the boys will be home by Christmas.

As for Vietnam, that did not exactly turn out as planned either. Predicting financial markets can be done, but their accuracy is as much a matter of luck and intuition as of skill and sophisticated modeling. There are just too many of these events that can happen. All manner of factors can nullify even the most complex modeling, because one just cannot include the truly unknown into the model.

This does not mean that modeling and prognoses cannot or should not be done. But we cannot and should not rely on them all that much. We also need to rely on intuition, common sense and simplicity. Furthermore, investment portfolios need to be made as crisis and black-swan-proof as possible. Our old friends, diversification, ongoing monitoring, rebalancing and so on, are less likely to let us down than models that are fundamentally incapable of taking everything into account.

In fact, the most reliable prediction is probably that the future will continue to remain a mystery, at least in part. There is a need to stop and summarize the triplet: A small number of Black Swans explains almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives.

black swan theory stock market

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Definition of 'Black Swan Theory' - The Economic Times

Human Behavior Classic events, based on Taleb's theory, include the rise of the internet and personal computer, the September 11 attacks and World War I. Strategy Plan to Cope with a Black Swan Event?

What benefits can be derived by considering this type of event in your strategic plan? How statistically significant are these outlier events?

We often hear that there are three types of people: Those that make it happen; 2. Those that let it happen, and 3. Those that don't know what happened. It applies to black swan events in the stock market. The action you undertake in this incidence depends greatly on what category you put yourself in! Conclusion Predicting financial markets can be done, but their accuracy is as much a matter of luck and intuition as of skill and sophisticated modeling.

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