How to prepare for Black Swan event

??????Recently, an RBI study – Capital flows at Risk, estimated that almost $100 Billion (3.2% of GDP) will be withdrawn from Indian market by foreign investors. It may cause “Black Swan” like event, the report stated. Let’s understand the term “Black Swan”.

?????Until 17th century, Europeans used to think that there are only White Swans in this world. This changed in 1697 when Willem de Vlamingh spotted a black swan in Australia. It radically changed the worldview of Europeans. The term “Black Swan” is used to describe an event which was unexpected and makes a huge impact on the society/world. There are three parameters to decide whether an event is a Black swan event or not-

1.?????It should be an outlier

2.?????It should have an extreme impact

3.?????It should be explainable after it has happened

World War I & II, fall of Soviet Union, 9/11, 2008 global economic recession are some of the examples of black swan events. In corporate world, it’s important to be prepared for Black Swan events. It may make or break your organization. In order to prepare for such an event, it’s important to avoid different fallacies that human beings fall prey to-

1.?????Narrative fallacy

Human beings tend to form a story to explain past events. We’re more interested in stories than in statistics. We accept compact stories over raw and unfiltered truth. It distorts our mental representation of the world. Forming a logical link between random events to give meaning to them makes us feel right, but it can be detrimental in long term and may also lead to wrong decisions. Whatever happens in past is usually random and unplanned, but we interpret it by linking one event with another, thus forming a narrative.

2.?????Roundtrip fallacy

Most people confuse absence of evidence as evidence of absence. For example, people might confuse between “No evidence of aliens” with “evidence of no aliens”, which is essentially a roundtrip fallacy. Like mentioned earlier, Europeans till 17th century assumed lack of evidence of black swans as evidence of no black swans, which was not really the case. We need to be consciously aware about things that has no evidence, but also no evidence of absence.

3.?????Confirmation bias

A kind of cognitive bias in which people search for pieces of information that supports their existing beliefs and ignore those pieces of information that threatens their belief system. A typical example would be a democrat will ignore news articles and videos from Fox News, while reading and watching CNN, MSNBC etc. We even interpret facts in such a way that it will support our existing beliefs. If we want to be prepared for black swan event, we need to be aware of our confirmation bias and try to break the bubble in which we live.

4.?????Ludic fallacy

Originated from Greek word ludus meaning “play, game, sport”. People assume that probabilities and statistics that work in games will also work in real life situations, which is not true. Human beings are confident that they know all the possible risks associated with something, which is usually not the case. For example, a casino owner will spend millions of dollars on surveillance system, security etc, but it’s still not enough to secure his business against all the risks associated with casino. The famous example is of Stephen A. Wynn- a casino mogul whose daughter was kidnapped and he had to pay ransom of $1.4 Million. It was not the risk he anticipated with respect to his casino business.

As a human being, we fall prey to many psychological fallacies which limit our potential. If we’re aware about them, we stand a chance to perform better than others.

Source - The Black Swan : The impact of the highly improbable By Nassim Nicholas Taleb