Christmas season is as good a time as ever to remind you that a probability distribution has two tails. Event distributions have been getting a lot of attention over the past several years, especially their tails.
It used to be that Wall Street was functioning on the basic idea that financial events were subject to something very like a normal distribution, also known as a bell curve. Since they saw stock and bond prices as largely random variations from the average, they saw the risk to their portfolios as relatively low.
Sure, once in a while a fair flipped coin will give you ten heads in a row, but not often enough to worry about. So, big trading houses made very large bets believing their risks to be very low. Then the crisis came and the financial world was sent scrambling for understanding.
Nassim Taleb advanced the notion that investors have a cognitive bias against events they have never seen. This is similar to naturalists who denied the existence of black swans because they, or their fellow naturalists whose writings they have consulted, had never seen one. But, argues Taleb, just because you’ve never seen a black swan does not mean that all swans are white.
Some events are exceedingly rare, but may have consequences large enough to pose truncation risk on a business enterprise, such as Long Term Capital Management in the late 1990s. Some events are large enough to pose systemic risk, that is risk to the entire global financial system.
And if that risk is not taken seriously, the bets will be too big, big enough to shut