In this essay, Nassim Nicholas Taleb writes on the recent turmoil on Wall Street. He writes in an entertaining way and makes sure to mock a few financial ‘celebrities’. His basic message is that most people does not understand statistics. What he has in mind may seem like minor subtleties, but I trust him they are important. Here are a few quotes to tease your curiosity:
Are we using models of uncertainty to produce certainties?
I have nothing against economists: you should let them entertain each others with their theories and elegant mathematics, and help keep college students inside buildings. But beware: they can be plain wrong, yet frame things in a way to make you feel stupid arguing with them. So make sure you do not give any of them risk-management responsibilities.
In the latter half of the essay, Taleb discusses the inverse problem (the greatest epistemological difficulty he knows) and his way of getting to grips with it. This involves fractal power laws and is very superficially described. He repeats that the details are spelled out in the appendix, and I am sure they are. Unfortunately, however, parts of the essay presents itself as half-scientific nonsense to me.
Taleb ends his essay with nine ‘phronetic’ rules, a dos and don’ts in ‘the Fourth Quadrant’ (the part of real life that involves nonlinear payoffs). (Phronetic is from greek and can be translated into ‘practical wisdom’ or ‘prudence’.) The first: ‘Avoid Optimization, Learn to Love Redundancy.’ Another: ‘Do not confuse absence of volatility with absence of risks.’ And from the rule on metrics:
Conventional metrics based on type 1 randomness [random walk, I presume] don’t work. Words like “standard deviation” are not stable and does not measure anything in the Fourth Quadrant. So does “linear regression” (the errors are in the fourth quadrant), “Sharpe ratio”, Markowitz optimal portfolio, ANOVA shmnamova, Least square, etc.
Great stuff, I love this guy! Here is his homepage, check it out.