Innovation through IT

I thought it might be time for a post in English, not that I think that there are a major pull for the information on this blog abroad (there is barely any in Sweden!), but there might be, so hence be prepared!

In that sentence I basically summarized the view put forward by Nicholas Nassim Taleb's (from now on referred to as the acronym NNT) in the extraordinare book "The Black Swan". It is a book about knowledge, the limits of knowledge and the immense power of the unknowable, i.e. the things that we don't know that we don't know and how this affects our world much more than we would like to think of.

Let me start anecdotal with the story of the Nobelrid hedge fund Long Term Capital Management. I will not bore you with the technicalities of the fund (mainly because in my physics studies I did not venture into the econophysics branch so I do not understand the complex mathematics involved), it is suffice to say that the fund was highly leveraged and speculated according to a mathematical model that was based on the work of at least two Nobel laureates. The full story can be found here, I will just mentioned that the fund started in 1994, was extremely successful for a number of years but in 1998, the fund lost amounts estimated at $4.6 billion in an event probably triggered by the 1997 East Asian financial crisis.

The model according to which they traded did apparently not take into account the possibility for such an outlier as the East asian financial crisis. Implicitly, in their models, such unlikely events were truly unlikely, i.e. "not supposed to happen". Enter NNT (remember the acronym for Nicholas Nassim Taleb) and the concept of black swans. Black swans are events that are truly unlikely, nothing in the past would ever point to their existence (think 9/11, the stock market crash of 1987, the birth of Google, etc). Their second trait is that they impact the world immensly. Actually their impact is so large it overshadows everything else within their specific area, or even worse in finance, it actually overshadows everything. Their third trait is that, in hindsight, we believe that we can find a narrative that fits the event, "that we understand" the reasons for it occuring, even though we were absolutely oblivious to it up until it actually happened. The crash of LTCM was a black swan.

NNTs main point is that unlikely events are actually not that unlikely, they are only unlikely within the framework that we tend to view the world with in general, the standard deviation world of the Gaussian probability function. One main property of the Gaussian is that probability declines very rapidly when you move away from the average. Hence, applying the Gaussian to a situation where probabilities are in fact not Gaussian will dramatically underestimate the probability of an unlikely event. What kind of probability function do you think the LTCM was based on? If you think that Mr Nassim is right, and I must say, he puts forward very convinving arguments, one must accept the fact that the world is not only more volatile than we usually believe, it is also intrinsically associated with the fact that we can't estimate the probabilities at all. It is in fact, quite impossible to predict the future in any kind of sense. Yes, we can predict certain things quite well but in fact the high impact, improbable events called the black swans effectively erase the minute effects that the predictable might have. Let us do a thought experiment:

You are an analyst at a finance institution and the year is 1994 and a new thing called the internet and the world wide web had made something of a footprint in the marketspace. You try out something called a browser named Mosaic and you type an impossibly long array of letters in something called an adress field. You wait three minutes while you modem is doing its noicy task of talking to a server somewhere in the world and finally you see....plain ASCII text on a white background! Bored with the experience, since you are a man of flair, coiffure and the heir to the masters of the universe, you throw the investment prospect of a firm called Amazon in the waste basket with the words (that you later were famed and ridiculed for by your peer investors) "No one will by books in this lousy way. Let's put another $100 million dollars in the Long Term Capital Management hedge fund instead". In one instance you have missed a positive Black swan (the advent of Amazon) and fully bought into a negative Black swan, the collapse of the LTCM, where the former has been taking away "predictable" income for many of the later e-commerce ventures whereas the latter effectively erased the fund's initial successful years.

No one is able to predict the future so be wary of those who claim they can is a phrase that echoes throughout Talebs book. So what does this imply for those people engaged in innovation? In all essence, nothing much, what Taleb mentions has been a reality all along and well know among those living in the venture world, he just articulates it and makes us aware of the fact that we shouldn't listen to expert forecasters and people in suits (Ooops, I wear a suit quite often, actually every day) too much. Actually, he says don't listen at all but that might be streching a bit far.

True innovation in terms of not only improving existing structures but actually changing the structure itself is per se impossible to predict as well as it is impossible to assess the probability that such a structure changing innovation actually comes along at all. We live in a world of unknowledge as Taleb wisely puts it.

But we are in no place to fatalistically give up and surrender to forces more powerful than the Gaussian. An open mindset, a willingness tro try new ideas and an explorative mind are things that will helps us in the pursue of both truth and richness. Explore new ways of doing things, explore that path never taken before and see where it leads you; probably not towards a Black swan (cause remember they are still rather unusual) but then again you wouldn't know. Explore many things simultaneously to expose yourself to as many possible positive Black Swans as possible, don't risk everything on one bet, diversify (but not by using Sharpe ratios!) and be more afraid of missing an interesting opportunity than of the embarrasement of being ridiculed by the crowd.