There’s safety in small numbers

4th June, 2011

Running late for a flight, on a twisting Sicilian road, I overtook a large lorry while my view was obscured by another large lorry. All was well, but several weeks later I am still having flashbacks. I’d taken a bet against what my colleague John Kay calls the “Taleb distribution”, named after Nassim Nicholas Taleb, author of The Black Swan. When you bet against a Taleb distribution, you enjoy lots of small gains (I made my flight) but you also risk disaster.

On the roads, the risks are obvious enough, but in many contexts they will be hidden. When banks and insurance companies sold credit default swaps on subprime loan packages, they were receiving a stream of small payments in exchange for a risk of catastrophic loss. But the risk seemed very small: as Joseph J. Cassano of AIG commented as the credit crunch was beginning: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.” He was wrong by 11 or 12 orders of magnitude, which may be about as wrong as it’s possible to be in human affairs.

It will often make sense to bet with the distribution instead of against it, taking repeated small losses on the chin in exchange for the occasional big success. In derivatives markets, this is the trading strategy that Taleb himself advocated. It is the strategy of the successful venture capital fund, too.

It’s also the approach advocated by Peter Sims – a former venture capitalist – in an enjoyable new book, Little Bets. In one of many examples, Sims describes the American comedian Chris Rock’s agonising practice sessions in low-key comedy venues, scratching around for new material, and argues that it’s worth tolerating a lot of disappointments in order to make it big.

I agree with Sims, but here is the difficulty: these small failures hurt. That is the evidence from psychological research; it’s also what common sense tells us. And they are embarrassing, because while the “little bets” that Sims describes are good bets, until they pay off they may seem to other people to be as fantastical as wasting money on scratchcards.

In contrast, the world often admires those who bet against the Taleb distribution, who keep risking disaster but usually avoid it. As the small wins stack up – perhaps bloated through leverage – managers and colleagues will tend to see a safe pair of hands, not a dangerous driver.

The challenge, then, is to find institutions that support little bets – or to use Taleb’s term from the second edition of The Black Swan, “antifragile” institutions, which benefit from disruption.

Scientific institutions fit the bill. A single breakthrough, whether theoretical or in the laboratory, can make up for a hundred failed ideas, because the scientific process helps to refute bad ideas and disseminate good ones.

But the most ubiquitous antifragile institutions are markets. When markets work well, they are remarkable systems for sifting out the dross and spreading successful ideas. The printing press and the production line, for instance, only needed to be invented once. These ideas spread through imitation, mergers and the growth of successful companies. And when markets work it is not because of the power of the profit motive, but because this process of trial and error is incredibly powerful.

When faced with a complex problem, we should look for institutions that can quickly discard bad ideas and reward good ones – institutions which place themselves on the right side of the Taleb distribution, able to exploit each rare opportunity as it appears. That need not be a free-market approach, but it must be one which is able to experiment and to adapt.

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