From wikipedia: "The Black Swan theory (in Nassim Nicholas Taleb's version) refers to a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. Unlike the philosophical "black swan problem", the "Black Swan" theory (capitalized) refers only to events of large consequence and their dominant role in history. Black Swan events may also be called outliers.For instance, a simple model of daily stock market returns may include extreme moves such as Black Monday (1987) but might not model the market breakdowns following the September 11 attacks. A fixed model considers the "known unknowns", but ignores the "unknown unknowns"."
While as the old adages go "history repeats itself" and "those who don't learn from history are doomed to repeat it" The black swan theory gives a valuable lesson on expecting the unexpected. When too much of the world gets explained with mathematical models and complex computer modeling; much is based on the "known knowns" and the "known unknowns". The flaw in the complex models that modern finance operates under is that too much gets boiled down into complicated derivative equations that attempt explain varying amounts of chaos. Mortgages were packaged and then repackaged in complex instruments to reduce risk. The fuzzy math of derivative logic was to assume that we take the worst modern housing decline on record and add a little to it to be safe and use it as our worst case scenario. Little did the mathematical wizards that came up with these instruments realize that they themselves created a bubble of easy credit that would cause the worst housing contraction since the great depression. This was the "unknown unknown".
Now applying this same logic to the current swine flu outbreak, we must wonder what the "unknown unknowns" could be. Computer models are often used in preparation for an outbreak of pandemic flu. In allocating resources to preparedness it is critical that we try to model the possibilities. Most of these doomsday, worst case scenarios are viewed through the prism of the 1918 pandemic. But what are the "unknown unknowns". We know diagnosis and treatment is a quantum leap ahead from 1918. But so is global travel. A tortilla vendor in Mexico City sneezes on a tourist who flies back to Amsterdam that day and the snowball starts rolling down the hill. But that is a "known unknown", and I'm sure some bean counter has factored that into their actuarial table at the insurance firm. We need to concern ourselves with what we are not prepared for, hopefully we will not experience the "black swan" pandemic in our lifetimes.
