This article has been adapted from our sister site across the pond, Fool U.K.
Bulls, bears, hawks, doves -- and now Black Swans. The market has found a new animal-based metaphor.
And while the feathered version of the black swan is rare in the UK, its literary counterpart appears with increasing regularity in press stories covering unusual or unpredictable catastrophes. But what exactly is a "Black Swan"?
The older Black Swan
Confusingly, there are actually two quite different "black swans."
Most current references to the "Black Swan" use this term to describe an unexpected event with terrible consequences, which was not predicted before it happened but which comes to be seen as practically inevitable with the benefit of hindsight.
The Macondo oil spill is sometimes described as a "black swan event" because nobody -- nobody at BP
However, the Black Swan has another, older meaning. It started life as a concept by some philosophers to illustrate a fundamental point about the weakness of human knowledge: You cannot prove a general rule about a class of things, or about the future, from a collection of individual observations, but you can disprove such a rule with just one single individual observation.
Put another way: You may have seen thousands of swans in your life and noticed that they were all white, and, having reached a ripe old age, you formulate a rule that "all swans are white." Yet you can never be sure that this rule is correct, unless you know for a fact that you have seen every swan in the universe (and you will never know that). But if ever one black swan crosses your path, then your rule is demonstrably, provably false.
Always bet on red
This is all well and good for philosophers, but how is this older, more venerable Black Swan relevant to the modern investor? The answer lies in the extent to which investors rely on information about the past, particularly historical prices, to make predictions about the future.
In no other field of human endeavour is so much assumed about the future on the basis of information about the past. And the older Black Swan tells us this -- that no matter how clear the message from the past, you cannot use it to prove general rules about the future.
In other fields, this is self-evident. Imagine Manchester United is drawn against a non-league side in the FA Cup and you learn that Manchester United has never lost to a non-league side in the 140-year history of the FA Cup.
Would you conclude that this means that Manchester United always wins against non-league sides and therefore that Manchester United is certain to win this particular match?
No.
Manchester United willprobably win, but you will never bet your entire wealth on this outcome, an action that would be rational only if the Manchester United victory were certain.
This demonstrates the practical difference between knowing that a rule is true, and knowing that a rule is almost certainly true. In the first case you can bet the farm on the rule. In the second case you can't.
The magic rule of property prices
Yet investors make this mistake every day. One need only look at the subprime scandal, when honest and intelligent people built AAA securities from loans to individuals who had no jobs, no assets, and no prospect of even servicing their debts, let alone repaying them.
One of the core underlying rules on which the subprime edifice was built followed from the observation that, in the past, the United States had never seen a countrywide collapse in property prices. Property bubbles are as old as the United States itself, but they had always been confined to a particular region (often Florida).
This led to the natural, but fatal, inference that a countrywide property crash could never happen in the future, either: Past observations of property crashes led to the rule that property never crashes throughout the whole of the United States at the same time. So as long as your security included loans from across the whole of the United States, you were safe. Invincible countrywide property values would replace the unemployed borrower as the core source of value underpinning the security.
We know how this story ended.
The Swan's lessons
The older Black Swan tells us two things. First, because one cannot ever be sure that a rule about the future is correct, one cannot rationally commit all of one's wealth to that rule, no matter how compelling or how "obvious" it looks. In particular, one should treat data relating to past events (including past prices) with extreme caution and never allow observations about the past to define one's view of the future. No amount of past data or "backtesting" can prove a rule about what is going to happen next. Statistics about past prices can tell us how other people might be thinking today, but not what will happen tomorrow.
Second, one should never underestimate the importance of one's own research and one's own insights.
The rule that all swans are white was never logically provable. However, the first person to see a real black swan (in 1697) immediately knew that the rule that all swans are white was wrong.
The point about the "Black Swan" in the modern sense of the word -- the unexpected event with terrible consequences -- is that it cannot be predicted in advance, which means that we as a society must take steps to ensure that its impact is minimized rather than spending all of our resources trying to stop it from happening in the first place.
But the older Black Swan is out there, waiting to be discovered.
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