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Op Eds on Risk

Black Swans and Dragon Kings - What's the Difference?

Taleb’s Black Swan Theory defines a Black Swan event as a surprise event of major proportions, an extreme outlier. Examples are 911, Fukushima and the 2008 capital market failure.

Black Swans are a surprise because the consequence of them far exceeds what anyone had previously estimated, even using sophisticated risk analysis of low probablity events. In fact, the consequence of Black Swans typically exceeds the sum of all other lesser events of a similar nature. For instance, the financial consequences of 911, Fukushima or the 2008 market crash were all more than the respective sum of previous terrorism, nuclear or market events.

Sornette’s Dragon King Theory also focuses on extremely large adverse events, which Sornette refers to as Dragon Kings. Sornette explains that there are instabilities within complex systems: feedback, tipping points and other unappreciated correlations and dynamics. These undiscovered characteristics are nonlinear and can amplify consequence to extreme levels. Sornette also uses Fukushima as an example but further observes for instance:

·         10% of all cyber events cause 99% of the financial loss

·         the largest 5 epidemics in the last few hundred years have caused 20 times the fatalities of the other 1,363 epidemics.

Sornette’s mathematics are more conventionally academic and easier to understand than Taleb’s. Sornette shows that a DK consequence increases exponentially at a higher rate (i.e. obeys a higher power law) than the probability decreases. This gives a very “fat tail” to the loss distribution.

For the risk management practitioner, the Black Swan and the Dragon King are fundamentally the same: an unusually extreme event that was unforeseen by almost everyone, even when examining the far right tail of the loss distribution.

What are the lessons for the practical risk management?

The more complex a system, the more the opportunity that inherent instabilities, correlations and unknown system dynamics can create extreme consequences.

If one is dealing with relatively simply systems - e.g. mechanical, structural, electrical, transportative or chemical systems - the Black Swan/Dragon King potential is low. Complex systems - nuclear, social, ecological, political, information technology - are where the unforeseen extreme events may occur. 

Jack Gordon