The Black Swan

Have read Nassim Nicholas Taleb's book: The Black Swan: The Impact of the Highly Improbable. Highly recommended for modelers or those who think about their application.

Taleb, once a very successful derivative and options trader, now a professor at the University of Massachusetts, takes you on a wild and often idiosyncratic ride through financial modeling. No equations in the book, but it helps to have some basic statistics and econometric background. As close to a page-turner as a book like this can be.

Taleb writes about what he considers the total inadequacy of currently used modeling methods. This is mostly a full-steam attack on the mis-use of Gaussian methods (the Normal or Bell curve), which are the basis of modern portfolio theory, forecasting, regression and just about any statistical method that claims to be predictive. The Gaussians' small tails make it incapable of modeling anything even close to improbable. Our connected world is getting more improbable, thus these methods are increasingly wrong.

To be clear, it's not that the use of Gaussian methods are always wrong, though Taleb's style sometimes implies that. He is making the case that they have been used to underpin all of financial modeling methods, even when it makes no sense.

Along the way, Taleb tells a personal story (very unusual for a statistics book!) and trashes modern portfolio theory, Black-Scholes, Wharton, the Nobel Prize Committee, the use of narrative and most of the last twenty years of econometrics. He has received threats from the normally staid econometric community. He suggests that that Mandelbrot's scalable fractal methods are a better approach than Gaussian methods.

He says that modern practitioners of financial methods agree with him, though most academics do not. The formal methods do not work. Evidenced by the 1998 LTCM crisis, which came close to bringing down the entire global financial system. The formal methods could not deal with a 'black swan', a very improbable event by normal distribution standards.

The practitioners respond that the current portfolio risk methods are all they have today to create useful models. Mandelbrot's models do not give the predictions that current formal methods do. But if the predictions are wrong?

This is a big deal to large companie who use many techniques like forecasting, marketing mix and simulation models that are based on what Taleb is saying are flawed fundamentals in a world of increasing improbabilities. Also, WSJ Review.