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Recognizing when Black Swans aren't

This article was was funded by the Society of Actuaries (Risk Management) and published in the 2015 Aon-Benfield Emerging Hazards Conference Proceedings, held in Gold Coast, Australia.

Written by Guntram Fritz Albin Werther, PH.D. Professor of Strategic Management, The Fox School of Business, Temple University; With the assistance of R. Thomas Herget, FSA, MAAA, CERA.

This essay aims to help financial and insurance practitioners better recognize, assess and respond to largescale, large-impact rare events (LSLIREs), occurrences often wrongly labeled as unpredictable black swans.

The primary focus is on educating practitioners to better recognize LSLIREs by assessing such event’s background characteristics, emergence dynamics, logics and other foreseeable attributes. A secondary focus is educating practitioners to better respond to the opportunities-whether to limit damage or to take advantage of-that arise from what others are likely to miss or misjudge during and after LSLIREs.

The goal is to foster better industrywide education, training and practice to decrease the range and scope of events that risk management professionals will henceforth label as being unpredictable black swans. In short, we want to discuss “When Black Swans Aren’t”. This effort is ultimately about building comparative advantage though better practice.

There are, of course, true black swan events: large-scale, large-impact rare events that really are unpredictable using current assessment and forecasting methods.
Nevertheless, Nassim Nicholas Taleb’s famous book The Black Swan: The Impact of the Highly Improbable seems significantly responsible for overpopularizing black swan thinking to such an extent that it currently supports particular views about theoretical limitations on what is commonly thought to be the realm of the possible. Such views about possibilities and impossibilities thus also guide current practical judgments of best-practice limitations in world affairs’ change assessment, in forecasting (or rather nonforecasting) of LSIREs and also in risk management.

Taleb’s arguments about black swans are based upon various assumptions and assertions he makes about:

  • complexity and the nature of change;
  • societal driving and shaping forces;
  • human and practitioner limitations (even when he is confronted by forecasters’ successes)
  • using philosophy, history and experience as guidance;
  • the limitations of learning and of being worldly learned;
  • human cognition limits;
  • the hard-deck limitations on the potentials of forecasting art and science; and hence, overall guidance of what constitutes best practices.

His scope is breathtaking and conclusions such that it behooves thoughtful professionals to closely examine both. Examining The Black Swan’s grounding ideas and claims is a transitory task in pursuit of the better practice objectives described above.

The essay proceeds through four subject themes, although the holistic nature of the task coupled with the naturally interpenetrated proclivities of a holistic-thinking style blends them-hopefully well-into an overarching argument where elements of each theme may emerge here and there. These four section themes and associated tasks are:

The definition of a true black swan versus what are now almost universally perceived as being such (LSLIREs). This discussion looks at current methods for trying to detect mass-perceived black swan (LSLIRE) events, comments upon why current recognition methods usually fail, and suggests what fostering better recognition, assessment and response may look like.

Engagement in a fair but tough-minded assessment of the strengths and weaknesses of Taleb’s book The Black Swan, with particular focus upon his assertions and proofs about methods, philosophies and operational factors that impact the recognition, assessment and response to what he terms black swan events. The task herein is to separate the correct from the more dubious aspects of his argument, and thereby improve finance and insurance community usages and results. Partly this involves looking at foreseeable first, second to nth order effects of Taleb’s claimed black swan occurrences.

Having separated, to an improved extent, true black swans from large-scale, large-impact rare events, the discussion next addresses potential solutions to better recognizing (forecasting) emerging LSLIREs, and also suggests ways to better protect oneself and/or seize new opportunities that come during and after either a black swan or LSLIRE occurrence. Commentary is given on the benefits of integrating several recognition and assessment methods to produce more robust and holistic foresight and insight. Also covered is natural system versus human-involved system LSLIRE emergence recognition, with commentary on aspects of typical societal reactions to both types of events. Sounder within and after-event judgment facilitates turning downside risk into future opportunity.

Finally, the discussion covers difficult aspects of reducing the uncertainty related to better timing (improved time-scale recognition and assessment) of emerging LSLIREs, and thus of better foreseeing emerging tipping or trigger points (syndrome shifts) within an LSLIRE occurrence, and of using shifting analyst’s cognitive dynamics at or near these time points.

Analysts’ cognitive behaviour surrounding an LSLIRE emergence is presented herein as a critical tool for reducing what many now perceive as true black swans to a more manageable large-scale, large-impact, rare-event status: still hard to foresee but certainly not impossible. Comparative advantage again arises here.

This is a difficult and important topic. Nothing in the discussion is meant to impinge upon an appreciation of Taleb’s positive contributions to a debate and understanding of true black swan events. The discussion is, however, explicitly meant to build upon those contributions, and thereby improve theory and practice.

Read the full article here.

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