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The Black Swan: The Impact of the Highly Improbable is a philosophical treatise on uncertainty that managed both to entertain readers and to predict the financial meltdown of 2008. Nassim Nicholas Taleb—the book's author, who is also a trader and university professor—has reissued his 2007 best seller in a second edition that includes a new 73-page essay, "On Robustness and Fragility."
Businessweek.com interviewed Taleb in early July about his views on investing and the dangerous Black Swans—i.e. unpredictable events with big consequences—that could lie in wait for financial markets. Edited excerpts from the conversation follow:
Q: The new edition of The Black Swan includes what you call "10 principles for a Black-Swan robust society." One of them is: "Citizens should not depend on financial assets as a repository of value and should not rely on fallible 'expert' advice for their retirement." Can you explain what you mean?
Taleb: The problem is that citizens are being led to invest in securities they don't understand by people who themselves don't quite understand the risks involved. The stock market is probably the best thing in the world, but the true risks of the stock market are vastly greater than the representations. And this leads to extremely strange situations in which, say, someone has a bakery, is extremely paranoid about suppliers, very careful about risks, and protects his business with appropriate insurance. Then, at some point, he puts his $122,000 in savings in a fund that he knows nothing about, based on risk measures he knows nothing about, in companies very few people know much about.
People use "risk measures," but you're really not measuring anything like you measure temperature or distance. You are making a speculative assessment of a future event. That's not measuring, that's estimating. And as we saw with BP (BP), with the banking system, and with Toyota (TM), companies themselves are hiding risks from the security analysts. They're cutting corners. Companies have a tendency to hide risks.
So someone extremely careful and prudent in the management of his own affairs will be completely careless with the half of his savings invested in the stock market. I'm saying: Don't use the stock market as a repository of value. It has vastly more risks than you think.
I was at an investment conference last week with mutual fund managers and financial advisers. There were a surprising number of mentions of the possibility of "Black Swans," and your name came up. Do you think those people understand the concept?
No, they don't get it. My Black Swan idea is very different: There are events that you can't forecast, and you need to be robust to these events. If I think that someone doesn't understand Black Swans, I'm sure that whatever bad news happens to him will be Black Swans for him but "white swans" for me.
What should you do with your savings?
We have this culture of financialization. People think they need to make money with their savings rather with their own business. So you end up with dentists who are more traders than dentists. A dentist should drill teeth and use whatever he does in the stock market for entertainment.
People should have three sources of variation in their income. The first one is their own business that they understand rather well. Focus on that. The second one is their savings. Make sure you preserve them. The third portion is the speculative portion: Whatever you are willing to lose, you can invest in whatever you want.
In the second category—preservation of value—you should have the consciousness that there is something called inflation. You should avoid some classes of investments that are very fragile.
What are are potential sources of fragility or danger that you're keeping an eye on?
The massive one is government deficits. As an analogy: You often have planes landing two hours late. In some cases, when you have volcanos, you can land two or three weeks late. How often have you landed two hours early? Never. It's the same with deficits. The errors tend to go one way rather than the other. When I wrote The Black Swan, I realized there was a huge bias in the way people estimate deficits and make forecasts. Typically things costs more, which is chronic. Governments that try to shoot for a surplus hardly ever reach it.
The problem is getting runaway. It's becoming a pure Ponzi scheme. It's very nonlinear: You need more and more debt just to stay where you are. And what broke [convicted financier Bernard] Madoff is going to break governments. They need to find new suckers all the time. And unfortunately the world has run out of suckers.
You're saying that what is supposed to be the safest place to invest, government debt, is in some ways the most dangerous?
Unless you invest in your own home currency in very short-term Treasury bills. Because governments can print more of their own currency, the risk comes from a rise in interest rates rather than a government default. When you have hyperinflation, deficits, or debt problems, with short-term bills you can catch higher interest rates to compensate you for the inflation or whatever return you've missed.
I think some people get confused about Black Swans and think you're saying that you can't predict what's going to happen. But you can see some big consequential events coming down the road.
A Black Swan for the turkey is not a Black Swan for the butcher. For someone very naïve, some events may be Black Swans. For someone warned, they're not going to be Black Swans if you know they can be possible and you hedge against them.
Do you have any thoughts on the U.S. financial reform package?
I don't like complicated regulation. I think we should not need financial reform. What we need is definancialization. What we need to do is break the financial community's grip on society. And you can do it very easily by transformation of debt into equity. Banks have an interest in building debt, but equity in society is vastly more stable than debt.
So the problems have not been addressed. They're making something that was complicated even more complicated. We need some fundamental reforms rather than a very, very precise guideline on how you should behave.
What are you working on now?
My next [book] is about beliefs, mostly. How we are suckers and how to live in a world we don't understand.