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Dragon King beats Black Swan: Ted Talk with Didier Sornette

2013/06/18

The other day, on Pragmatic Capitalism Cullen Roche drew our attention to a fascinating Ted Talk by Didier Sornette about: How we can Predict the Next Financial Crisis.

Didier Sornette has an impressive CV which shows that he is

Professor of Entrepreneurial Risks
Professor of Finance at the Swiss Finance Institute
Director of the Financial Crisis Observatory
Founding member of the Risk Center at ETH Zurich
Associate Member of the Department of Physics (D-PHYS), ETH Zurich
Associate Member of the Department of Earth Sciences (D-ERWD), ETH Zurich.

Furthermore, he is the author of a much-noticed book on Why Stock Markets Crash: Critical Events in Complex Financial Systems.

In the Ted Talk, Didier Sornette presents his concept of the “Dragon King”.

He starts from the observation that the great recession of 2007/2008 has shattered the idea that the economy has transformed to a world of everlasting growth and prosperity. In a chart he illustrates how a few hundred billion dollars of losses in financial markets “cascaded” into 5 trillion dollar losses in world GDP and about 30 trillion dollar losses in stock markets.

As he says, the general understanding is that the crisis came as a complete surprise. To the initiated, his choice of the word “cascaded” to describe the dynamics at work indicates that he has a different view. His hypotheses are

(1) Financial bubbles can be diagnosed in real-time before they end, and

(2) the termination of financial bubbles can be bracketed using probabilistic forecasts.

His underlying concept is the theory of “Dragon Kings”:

Dragon Kings represent extreme events which are “in a class of their own”. They are special. They are outliers which are generated by a specific mechanism which, as Sornette emphasizes, makes them “predictable and perhaps controllable”.

Studying the distribution of peak-to-valley losses of a financial time series, Sornette explains that a large part of these losses can be represented by a power law.

NB: The best short explanation I came upon for a power law is by Philip Ball in his book The Self-Made Tapestry: Pattern Formation in Nature (p. 193). In a system following a power law “some property of the system [such as energy or mass …] is proportional to a variable (commonly a size scale) raised to some power (called the scaling exponent).” A little later (p. 210), he mentions as an example Per Bak’s sand pile [which I described elsewhere]: “The number of landslides decreases as the number of grains it involves increases, and the relationship between the two is a power law” – a kind of (inverse) relationship between the size of the event and the probability that it will attain that size.

However, Sornette continues, there are outliers which occur one-hundred times more frequently than predicted by this law – the Dragon Kings. They are the result of dependencies where a loss is followed by a loss is followed by a loss …

As Sornette describes vividly, the mechanism of a Dragon King is a slow “maturation” to the instability of a bubble – he compares the dynamics to the slow heating of water to the boiling point – and the climax of the bubble is the crash.

Sornette stresses that any tiny perturbation can make this instability occur.

Do you remember the idea that the flap of a butterfly wing may cause a tornado in Texas?

The process “is the reflection of a collective emergent behaviour which is fundamentally endogenous”. The instability does not come as a shock from outside. It is inside, developing as a characteristic of the system.

The “irrational exuberances” of financial markets, as of all complex systems, are “At Home in the Universe”, to quote the title of a famous book by Stuart Kauffman.

At this point, Sornette contrasts his Dragon King to Nassim Nicholas Taleb’s Black Swan:

A black swan is a rare bird. Seeing it shatters all beliefs that swans should be white. The black swan stands for the idea of unpredictability and extreme events being “fundamentally unknowable”.

As Sornette emphasizes, the Dragon King is “exactly the opposite” of a Black Swan, as in his concept, most extreme events are actually knowable and predictable.

Well, this is only a brief glimpse to whet your appetite for more. Enjoy the talk:

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