Of Black Swans and Volatility

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Book cover of ‘The Black Swan: The Impact of the Highly Improbable’, a literary/philosophical book by the epistemologist Nassim Nicholas Taleb – considered as one of the best book in the field of Behavioral Finance.

The tale of black swans and finance might be seen as abrupt and sudden but the concept plays an integral part in the definition of finance overall. The term was coined by Nassim Taleb and is one of the most important covenants of behavioral finance. The word comes from the anecdote that it was thought that black swans did not exist in the world until there was a discovery of one and since then that paradigm had been broken leading to the development of a new world that resolved the old perspective with the new and lead to the development of the new world view.

Taleb says that in finance drastic and extreme events are similar and that they do occur on a regular basis. Most of the finance theory has to take some assumption in order to make the formulas and equations work. Like in a science experiment, the conditions are put in place and they are controlled in order to see what the outcomes are. Due to this, most of the financial theory is centered on the normal distribution which says that the outcomes reach a mean of zero and that deviations from the mean fall as you move further and further away from the center. Due to this, the likelihood of an extreme event occurring are near to zero so they can be ignored.

Nassim Taleb tries to break this mold and points to the last 21 years from 1987 to 2008 itself only. Even in a span of these many years, events like Black Monday, September 11 attacks, the Russian debt default and the financial meltdown of 2008 show that even though these events could not have been expected even in the wildest models. The use of traditional financial theory would not have accounted for one such event let alone 4 of them but in reality they did occur. The scientific experiments seem to work very well under controlled circumstances but as soon as reality is introduced, the model fails to account for actual events.

Taleb’s view deserves its place and should be heeded to as well. The same has been said by Mandelbrot and Malkiel before them who have already said that the market is too random to be predicted. The variables in the model are just too complicated to model. In addition, the model that would be created would be based on past data and might not apply to the future. So where do we stand now? The first thing is that we do need some sort of framework to model the markets. These models allow to price risk and return and allow us to see what the market should be.

The models that have been developed are capable of doing that. In order to incorporate the black swan view, additional risk should be taken into consideration. The risk associated should be increased in order to take into account future unforeseen extreme events and so by combining the traditional and behavioral elements of the two sides, a new view can be created. In case the next black swan comes round, markets would be prepared against it rather than shocked and surprised by it.

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