Maggie's Farm

"Why Doctors (And Everybody Else) Should Read Books by Nassim Taleb"

Good article. This point from the article is spot on: “a ‘2% chance of being wrong’ is meaningless without [also] knowing what the consequences of being wrong are.” My field was lending (I am retired), not medicine. So we thought about losing money, not losing lives. But we certainly thought about this concept. We used the terms probability of default (PD) and loss given default (LGD). In other words, you had to think about both the probability of bad things happening (PD) and how bad it would be if bad things did happen (LGD). We talked in terms of risk equals PD x LGD. This simple equation doesn’t work, however, when the LGD is binary (you live or you don’t).

This concept is why big banks are a problem. A large, diversified bank likely has a lower PD than a small community bank with loans concentrated in one area. But the big bank has a much greater LGD, especially in terms of collateral damage to other institutions and the overall economy.

A classic example of this concept is the instance cited in the article that caused the author to sit up and take notice of Taleb’s message: the failure of Fanny Mae. (Yes, Taleb did say Fanny Mae. Most people say Fannie Mae.) Fannie Mae’s PD was small, but its LGD was huge. Taleb made the comment quoted in the article in 2007 in The Black Swan in a footnote on pages 225-226. Fannie Mae and its cousin Freddie Mac, both huge financial institutions, were placed into conservatorship by the federal government on Sunday, September 7, 2008. That was likely the last straw for Lehman Brothers, which filed for bankruptcy on Monday, September 15, 2008 – “triggering the financial collapse of 2008” as the article notes.

Taleb nailed that one. But I don’t agree with his position on climate change. He says that while the probability of catastrophic warming is small, the consequences of ending up like Venus are so huge that we need to do everything possible to prevent that outcome. The problem with this line of thinking is that there is also a nonzero probability of catastrophic cooling. After all, the Earth has in the past been warmer than it is now, and the climate did not spiral out of control into catastrophic warming a la Venus. But there have been multiple ice ages in our past, and there is no certainty that there won’t be ice ages in our future. The climate is always changing. We simply don’t understand enough about natural variability.