Nassim Nicholas Taleb, in his insightful books, explains that most of us think we live in a world dominated by averages and normal distributions, when in fact the things that matter most are those governed by “scalable” or power distributions.

One of his examples is the turkey, who lives every day of his life happily roaming the farm, pecking on corn, getting his fill, being treated nicely by the farmer, and goes to sleep each night knowing that the next morning will be just like the last. Until one day the friendly farmer picks him up, carries him to the back yard, chops off his head, stuffs him, and throws him in the oven.

Probabilities

Every day, millions of people around the world remove their shoes to clear security at the airport — not because one idiot put some explosives in his shoes and was caught trying to light them on fire 15 years ago, but because legislators and regulators think they can prevent bad things from happening in the future by passing bills that focus on what happened in the past. The United States of America holds the world record on gun violence, people in prison, corporate profits with few employees, influence of press and advertising, failing education, expensive and inefficient health care, a fragile banking system, and economic inequality. These things are related. They are all part of a system that is prone to catastrophic failure.

Nassim Taleb simplifies this into four quadrants:

Outcomes

Another way to look at this is that the distributions on the left side are fairly easy to model, while the upper-right quadrant includes “known unknowns,” and the lower right quadrant — the black-swan domain — includes “unknown unknowns.” According to Taleb, if you pay 10% attention to everything in the other three domains and give 90% of your attention to the black-swan domain, you will likely be much better off than the other way around.

Summary

Today we use better statistical models that include many different kinds of “outlier” possibilities and run Monte-Carlo simulations that have randomness built-in. We use a common language of probability distributions, rather than predictions. And we build portfolios that are properly hedged against unforeseen events. According to the few companies that do this kind of work, most organizations are in the stone age when it comes to identifying and managing real risk.

For Further Reading

Hubbard Research

Disaster Avoidance Experts

Beyond Budgeting

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