How is Wall Street like the Titanic? The author of The Black Swan has a theory.
In his 2007 book, The Black Swan: The Impact of the Highly Improbable, Nassim Nicholas Taleb writes that banks are so connected that ‘when one falls, they all fall.’ He worries that we still haven’t seen the worst. ‘Everyone is in denial. The car is in the middle of a crash and the parts are still flying, and we don’t know how far they are going to fly; The situation is vastly more dangerous than the Great Depression.’ Reason: So many more people own stocks now, thanks to the proliferation of 401(k)s.
The problem with Wall Street, he says, is that (a) it’s in the business of hiding risk and (b) it greatly underestimates the probability of outsize moves.
The human mind, evolved to cope with everyday risks, deals poorly with rare (‘unpredictable and extreme’) but consequential events (which Nassim argues dominates our story). People assume that the future will be like the recent-past, but in fact, the most consequential events may not have recent-precedents. For economists, the problem is compounded by a lack of long-term historical data to study rare events, like nationwide real-estate busts. ‘It’s a fundamental problem with economics,’ admits Yale’s Robert Shiller, who says Nassim Nicholas Taleb, unlike most Wall Street pundits, ‘speaks openly and honestly about the nature of financial risk.’
Taleb isn’t the first to notice the fat tails on the probability curves. The late, great Mathematician Benoit Mandelbrot, known for his work on fractal geometry, noted this property of the financial-markets in the 1960s. But he says his paper was ignored because extreme price swings made calculations difficult. ‘People just cut them away by calling them outliers,’ says Benoit; an emeritus professor at Yale University. Nassim Nicholas Taleb independently ‘figured out that large price changes are much more important than anyone else is giving credit for.’