Wednesday, August 23, 2006

More Black Swans..

Strangely, the day after I wrote this post about black swan events and mentioned the current terrorist threat in it, Daniel Finkelstein has this opinion piece in The Times today making some interesting points - again motivated by Taleb's quirky book. He points out the difference between probability and expectation and that our brains don't comprehend the difference very well. I have some issues with the argument.

The argument Taleb makes goes something like this. A low probability event may be disproportionately high impact so we should treat it differently. It may be entirely rational to short the market even if you expect it to go up because you think that if it goes down, it will go down a lot.
Taleb's investment philosophy is based on that. The problem with this is that it is overly simplistic. Most people have a specific time frame for realising their investment returns. Whilst in theory it may make sense to wait for a crash to make money, our patterns of expeditures are steady over time and therefore a steady stream of moderate returns has more appeal than Taleb ( and Finkelstein ) expect. Ultimately, the crash may not happen during an investment lifetime and by creating a strategy that is exclusively focussed on low probability events, we run the risk of running out of money and ending up significantly worse if the event does not occur.

Basically I think the argument needs to consider finite time and funds before creating a strategy linked to the mispricing around black swan events.

In any case, an article quoting a similar point ( from the same book) to one made on an obscure blog appearing on the front page of The Times one day after it was posted is probably a significant Black Swan event in its own right !

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