Black Swan Event
Long-Term Capital Management, founded by Nobel laureates Robert Merton and Myron Scholes, used sophisticated portfolio theory models that excluded extreme events. When the Russian financial crisis triggered a Black Swan in 1998, the firm collapsed, nearly taking down the global financial system—demonstrating the catastrophic risk of ignoring rare, high-impact events.
THE IDEA
IT WAS JUST A BLACK SWAN
Robert Merton, Jr., and Myron Scholes were founding partners in the large speculative trading firm called Long-Term Capital Management, or LTCM, which I mentioned in Chapter 4. It was a collection of people with top-notch résumés, from the highest ranks of academia. They were considered geniuses. The ideas of portfolio theory inspired their risk management of possible outcomes—thanks to their sophisticated “calculations.” They managed to enlarge the ludic fallacy to industrial proportions.
Then, during the summer of 1998, a combination of large events, triggered by a Russian financial crisis, took place that lay outside their models. It was a Black Swan. LTCM went bust and almost took down the entire financial system with it, as the exposures were massive. Since their models ruled out the possibility of large deviations, they allowed themselves to take a monstrous amount of risk. The ideas of Merton and Scholes, as well as those of Modern Portfolio Theory, were starting to go bust. The magnitude of the losses was spectacular, too spectacular to allow us to ignore the intellectual comedy. Many friends and I thought that the portfolio theorists would suffer the fate of tobacco companies: they were endangering people’s savings and would soon be brought to account for the consequences of their Gaussian-inspired methods.
None of that happened.
Instead, MBAs in business schools went on learning portfolio theory. And the option formula went on bearing the name Black-Scholes-Merton, instead of reverting to its true owners, Louis Bachelier, Ed Thorp, and others.
When to use it
A financial institution evaluating investment risks should stress‑test portfolios against extreme market scenarios rather than relying solely on standard deviation measures.
A supply chain manager preparing for disruptions should develop contingency plans for low‑probability, high‑impact events such as natural disasters or geopolitical shocks.
An entrepreneur launching a new product should consider how unexpected market shifts could render their assumptions obsolete, and build flexibility into their business model.
A policymaker designing financial regulations must account for the possibility that the most severe crises are the ones no model has yet captured.
FROM THEORY TO EVERYDAY LIFE
In practice
Long-Term Capital Management (LTCM) Collapse
In 1998, LTCM, led by renowned economists and Nobel laureates, used models based on portfolio theory that assumed normal distributions and excluded extreme events. When a Russian debt default triggered a cascade of market turbulence, LTCM's highly leveraged positions led to catastrophic losses, forcing a Federal Reserve‑backed bailout and nearly destabilizing the global financial system. Dismissing Black Swan events in risk management is dangerous.
A MOMENT TO REFLECT
Put it to work.
What assumptions in your own decision‑making models might cause you to overlook rare but high‑impact events?
How can you build resilience into your strategies to withstand Black Swan events that historical data cannot predict?
In what ways do you rely on bell‑curve thinking, and how might that expose you to tail risks?
Often confused with
CONTINUE THE CONVERSATION
Source texts
- The Black Swan The Impact of the Highly Improbable With a new section On Robustness and Fragility (Nassim Nicholas Taleb)