The first (stuffed) platypuses to arrive in England, sent by Captain James Cook and naturalist Joseph Banks, were thought to be a practical joke. How could such a strange animal exist? The idea of a black swan—all swans in the Northern hemisphere were white—was simply beyond belief.

The Australian black swan, or Cygnus Atratus, now holds a special place at the centre of philosophical debate. It has also become a byword for events in financial markets that catch us by surprise, with disastrous consequences. The events in Dubai are but a recent and fascinating example.

In the 19th century English philosopher John Stuart Mill stated that, "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion."

Black swans and what they reveal about our readiness to jump to conclusions are particularly important in finance. And they lie at the heart of an excellent book titled Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Taleb.

Russian roulette

Taleb argues that life is made up of chance events, that we're unable to assess the probability of these events with any accuracy, and that, even if we could, we're not wired to process probabilities effectively anyway.

This, he says, makes trading and investing difficult. But because there are always people doing well and badly (if only because of the huge numbers having a go), we tend to assume that there is great skill involved. But the balance of luck and skill varies greatly depending on what you're doing and how you're doing it. As Taleb explains:

"$10m earned through Russian roulette does not have the same value as $10m earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one's dependence on randomness is greater than the other.

"Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers, instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security."

Dubai World, the sovereign wealth fund that shoulders $US59 billion of the city state's $US80 billion total debt pile, recently announced it was seeking extensions on its loan repayments. The All Ordinaries index fell 130 points as a result, the largest drop in more than five months. To those that had begun to develop a "numbing false sense of security" following the Australian sharemarket's strong upward surge, it was a black-swan like shock.

Investors tend to believe that such events are, of their nature, unforeseeable and unpredictable and that we can't therefore account for them in our decision-making. Taleb argues that's foolish and wrong. In fact, he's developed a very profitable investment strategy to take advantage of the foolishness.

On Wednesday, we'll examine a few financial black swans, what they might mean for investors and how we can seek to insulate our portfolios from their effects. And we'll examine Taleb's investment strategy and how you might use it, too.

This article contains general advice only (under AFSL 282288).

Greg Hoffman is research director of The Intelligent Investor which provides independent advice to sharemarket investors. BusinessDay readers can enjoy a free trial offer at The Intelligent Investor website.

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