A Faustian Trade

Dangers of Embracing Black Swan Events

Idea in Brief

I. Faust

Johann Wolfgang Von Goethe wrote one of the greatest works of German literature ‘Faust’. The first part was published in 1808 and the second part in 1832. The main character Faust (a scholar and necromancer) makes a pact with the Devil (represented by Mephistopheles) who promises Faust unlimited knowledge, power, and enjoyment of life in exchange for his soul. In Goethe’s Faust, on the request of Gretchen, Faust is carried to heaven. In other versions of Faust, his soul is carried to hell by Mephistopheles.

In short, a Faustian trade is losing something far more valuable than what you get in return.

II. Origins of The Black Swan

The phrase “black swan” derives from a Latin expression; its oldest known occurrence is the poet Juvenal’s characterization of something being “rara avis in terris nigroque simillima cygno” (“a rare bird in the lands and very much like a black swan”). When the phrase was coined, the black swan was presumed not to exist. That’s how impossible a Black Swan was.

Nassim Nicholas Taleb, in his book ‘Fooled by Randomness’, asserts:

What we call here a Black Swan (and capitalize it) is an event with the following three attributes.

First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility.

Second, it carries an extreme ‘impact’.

Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

I stop and summarize the triplet: rarity, extreme ‘impact’, and retrospective (though not prospective) predictability. A small number of Black Swans explains almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives (source:wiki)

Not all high Sigma events are Black Swan events but a lot of them today are Black Swan events.

III. List of Black Swan Events

  • the Sept. 11, 2001, attacks on the World Trade Center and Pentagon;
  • a 75% decline in the Nasdaq;
  • the 2003 European heat wave (40,000 deaths);
  • the 2004 Tsunami in Sumatra, Indonesia (230,000 deaths);
  • the 2005 Kashmir, Pakistan, earthquake (80,000 deaths)
  • the 2008 Myanmar cyclone (140,000 deaths);
  • the 2008 Sichuan, China, earthquake ( 68,000 deaths);
  • financial derivatives roil the world’s banking system and financial markets;
  • the failure of Lehman Brothers and the sale/liquidation of Bear Stearns;
  • a 30% drop in U.S. home prices;
  • the 2010 Port-Au-Prince, Haiti, earthquake (315,000 deaths);
  • the 2010 Russian heat wave (56,000 deaths);
  • BP’s (BP_) Gulf of Mexico oil spill;
  • the 2010 market flash crash (a 1,000-point drop in the DJIA);
  • the broadening scale of unrest in the Middle East; and
  • Thursday’s earthquake and tsunami in Japan.

(source: http://www.schaefersblog.com/a-list-of-black-swan-events-since-911/)

IV. The ‘Fear Index’

VIX is the symbol for the Chicago Board Options Exchange’s (CBOE’s) volatility index. It is a measure of the level of implied volatility, not historical or statistical volatility, of a wide range of options, based on the S&P 500. This indicator is known as the “investor fear gauge,” because it reflects investors’ best predictions of near-term market volatility , or risk. In general, VIX starts to rise during times of financial stress and lessens as investors become complacent. It is the market’s best prediction of near-term market volatility (source: investopedia)

The VIX, together with the CBOE Skew Index, can be considered a good indicator of perceived uncertainity. The VIX is also known as a ‘Black Swan’ Index for its ability to predict once in a lifetime event such as the Gulf War. During the height of the financial crisis, the CBOE hit an all time high.

Today, the lines between truth and fiction are no longer discernible. Lets take an extreme example of an app called the Blue Whale below:

V. The Blue Whale

Ever heard of the Blue Whale app? Created by Philipp Budeikin, a 21 year old man from Russia, the blue whale app is said to be responsible for more than 130 suicides in Russia.The app encourages self-immolation through 50 tasks culminating in suicide. Philipp’s rationale is that he is ‘cleansing’ society. This is just one example of how the realms of possibility have been stretched to infinity and yet people digest it as a memory and move on. The story of the Blue Whale may not surprise many.

Let’s understand why Black Swan events are no longer remote possibilities:

a) Influence of the Media

The span of human memory today ranges from one high TRP event to the next so much so that disaster, terror, celebrity faux-pas and anything that increases viewership influences attention and leaves a very short term imprint on memory until the next news worthy event catches our attention.

Certainly, the media has its own incentives and it’s choice on what it deems newsworthy but then it could also be a reflection of what we have come to accept as normal and entertaining.

b) Self Fulfilling Prophecies

The world has witnessed such dramatic geopolitical and economic changes that ‘Black Swan’ events of the nature referred to by Nassim Nicholas Taleb have become so frequent that the opposite of the Black Swan i.e. assuming all improbable or less probable events as the new normal can turn into a self fulfilling prophecy where the darkest manifestations of the human spirit are embraced as routine and very probable.

c) Fear of The Unknown

Many people fret about jobs after a technological ‘Singularity’ (an event where computers surpass human intelligence) or life after Artificial General Intelligence (AGI). This fear can lead to a self fulfilling prophecy unless we make a focused attempt to retrain ourselves for an inevitability. Also, no one is sure when Singularity will be real.

To avoid falling into a collective downward spiral, it is important to recognize the following:

An Ageing Mind

There is empirical research that suggests that as humans age, their mindsets harden and they think they know-it-all. There is a tendency to treat age as its own merit.

Parting Thoughts

One of my Chinese friend had a very profound observation to share with me. He said that a security guard at any establishment asks the 3 most philosophical questions:

“Who are you? Where do you come from? and Where are you going?”

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Writer @ The Intersection of Finance, Tech & Humanity. Stories of a Global Language: “Money”. Contributor @ Startup Grind, HackerNoon, HBR. Twitter@akothari_mba