An apparently unusual event of very high impact.
Particularly one which - before it happened - was believed in error to be highly improbable, or even impossible.
The use of the term in finance derives from the widespread historical (and wrong) belief in the Northern hemisphere that black swans did not exist. This wrong belief was held in the period before the common occurrence of black swans in the Southern hemisphere had been reported in the North.
The concept was popularised in a 2007 book by Nassim Nicholas Taleb - "The Black Swan".
Taleb summarises the problem in risk management as "the confusion of absence of evidence of Black Swans (or something else) for evidence of absence of Black Swans (or something else)".
This means that the existence of financial "black swans" tends to lead to systematic under-assessment and understatement of financial risk.
Turning black swans white
- Taleb points out that black swan events depend on the observer, and the information and analysis obtained and applied by him or her.
- Being slaughtered shortly before Christmas is a black swan surprise for a turkey; especially following 1,000 days of consistent - apparently predictable - feeding and friendliness from humans.
- The slaughter of the turkey is not a black swan event for the human butcher.
- Turkeys need to gather more information and to analyse it.
- How not to be a sucker - A Black Swan is relative to knowledge - The Black Swan, 2010 pp40-44.
Robustness not fragility
The key message from Taleb's work is about seeking robustness and avoiding fragility.
- "You have to avoid debt because debt makes the system more fragile. You have to increase redundancies in some spaces.
- You have to avoid optimization. That is quite critical for someone who is doing finance to understand because it goes counter to everything you learn in portfolio theory....
- I have always been very sceptical of any form of optimization. In the black swan world, optimization isn't possible.
- The best you can achieve is a reduction in fragility and greater robustness.
- You may have heuristics, but not an optimization rule.
- I hope the message will finally get across because I haven't succeeded yet.
- People talk about black swans but they don't talk about robustness, which is the real lesson of the black swans ..."
- "... almost 99 cases out of 100 optimizations make you vulnerable and fragile ...
- ... [When a company becomes] more specialized with things, and it works better, the numbers look better. But your hidden risks rise and rise. And then when you are faced with a problem, you don’t know what to do about it, whereas in other cases you have more variations all the time. You have more fluctuations and, of course, you are a lot more robust."
- "... try not to predict the catalyst, which is the most foolish thing in the world, but to try to identify areas of vulnerability. [It’s] like saying a bridge is fragile. I can’t predict which truck is going to break it, so I have to look at it more in a structural form ...
- And then you learn not to try to predict which truck is going to break that bridge. But you just look at bridges and say, “Oh, this bridge doesn’t have a great foundation. This other one does. And this one needs to be reinforced.” We can do a lot with the notion of robustness."
- Living with Black Swans - Nassim Nicholas Taleb.
- Fat tail
- Green swan
- Guide to risk management
- Horizon scanning
- Optimal capital structure
- Portfolio analysis
- Stress test
- Weighted average cost of capital
Nassim Taleb on Living with Black Swans