The Black Swan and highly disruptive events

Wall Street Journal reporter Scott Patterson, in a July 13 article “Mr. Volatility and the Swan,” profiles Nassim Nicholas Taleb, with his book “The Black Swan: The Impact of the Highly Improbable” and his new investment fund, Universa Investments LP: 

“Mr. Taleb believes most investors underestimate the likelihood of seeing a black swan — which he defines as extreme, highly disruptive events that send shockwaves through financial markets — and that there are huge profits to be made in such conditions. (The title alludes to the belief in the West, widely held until European explorers discovered the black swans that are native to Australia, that all swans are white. To call something a black swan was to imply it didn’t exist.)”  “In it he argues that most investors don’t properly understand the risks they are taking and overlook ways to survive a steep market decline. Many investors plan for rainy days, he says, but not for tornadoes.  In part that is because the use of common measures of risk on Wall Street trick investors into thinking the past is predictive, he says. In particular he cites reliance on the bell curve — a chart plotting the distribution of data like stock prices or the heights of all people in a room. In normal distribution, the chart resembles a bell, with rare events being plotted at the bottom edge of the bell. His black swan events, however, fall so far on the outer edges of the bell that investors underestimate the odds that such events will occur. Thus, bets on market-rattling events can be made on the cheap.”