Nassim Nicholas Taleb is the author of The Black Swan, one of the most influential books of the past 50 years. The book is concerned with randomness and uncertainty, and our chronic inability to accurately fathom and measure these phenomena. According to Taleb, a Black Swan event is one that is unpredictable yet has wide-spread ramifications.
More specifically, a Black Swan event has to have the following three characteristics: 1) it was not predicted, meaning it came as a surprise (to the observer), 2) the event has a huge, widely-felt impact, and 3) even though the event was not expected or predicted, human nature causes the observer to believe that the event was perfectly predictable and foreseen.
The financial crisis of 2007-2008 is a perfect example of a typical Black Swan event. It fits the first criteria because most people did not expect such an event to occur. In fact, before the crisis hit, many people pointed to the fact that housing prices had not declined on a national level for decades, as if the fact that this hadn’t occurred meant that it was not possible for it to occur. The crisis obviously fits the second criteria of having a huge impact, as we are still trying to climb out of the hole the crisis created. And the crisis fits the third criteria, as many people who did not predict the financial crisis came out after the crisis occurred and claimed that the decline in housing prices was perfectly predictable. In fact, many people have been angry with politicians, regulators, and business executives for not preventing the crisis, when these same people had no idea themselves that a crisis was coming.
The third criteria for a Black Swan event, that the event becomes “predictable” only after it occurs, is probably the most interesting from a psychological perspective. It’s certainly a contradiction that an event becomes “predictable” only after it occurs, but it seems to be indicative of some naturally occurring biases, including the hindsight bias (i.e. hindsight is 20/20). The Incerto
As mentioned above, the financial crisis of 2007-2008 is a prototypical Black Swan event, and it is also the event that really shot Nassim Taleb into popularity. In fact, in the book, which was published before the crisis hit, Taleb mentioned that he would never invest in Fannie Mae and Freddie Mac because they seemed to be sitting on top of a timebomb with all of the mortgage-backed securities they had on their balance sheets. Of course, the value of these securities fell through the roof, Fannie and Freddie required massive bailouts, and Taleb ended up looking like a prophet.
Taleb spends a lot of time in his book going over the potential dangers of negative Black Swan events and how to avoid them, but he also points out that there are positive Black Swan events, and you should maximize your exposure to these. For example, the explosive growth of both the personal computer market and the internet were both positive Black Swan events that no one foresaw, had a massive impact, and were thought to be predictable only after they happened.
As protection against negative events, Taleb developed his “barbell” strategy, where you ignore stocks in the middle, invest most of your assets in ultra-safe investments like T-bills, and then invest a small portion of your portfolio in assets that offer a huge payoff if they pan out, such as out-of-the-money options or very-small-cap stocks. This “barbell” strategy can protect you from negative Black Swan events while still giving you exposure to positive ones. In fact, Taleb’s hedge fund earned a massive return in 2008 using just such a strategy.