Electronic copy available at: http://ssrn.com/abstract=1343042
© Copyright 2009 by N. N. Taleb.2
Forecasting is a serious professional and scientificendeavor with a certain purpose, namely to providepredictions to be used in formulating decisions, andtaking actions. The forecast translates into a decision,and, accordingly, the uncertainty attached to theforecast, i.e., the error, needs to be endogenous to thedecision itself. This holds particularly true of risk decisions. In other words, the use of the forecast needsto be determined –or modified – based on theestimated accuracy of the forecast. This, in turn createsan interdependency about what we should or shouldnot forecast –as some forecasts can be harmful todecision makers.Figure 1 illustrates such example of harm coming frombuilding risk management on the basis of extrapolative(usually highly technical) econometric methods,providing decision-makers with false confidence aboutthe risks, and finding society exposed to several trillionsin losses that put capitalism on the verge of collapse.
Figure 1- Fat tails at work. Tragic errors from underestimating potential losses, best known cases:
FNMA, Freddie Mac, Bear Stearns,Northern Rock, Lehman Brothers, inaddition to numerous hedge funds.
A key word here,
, implies the outsized role inthe total statistical properties coming from one singleobservation –such as one massive loss coming afteryears of stable profits or one massive variation unseenin past data.- “Thin-tails” allow for an ease inforecasting and tractability of the errors;- “Thick-tails” imply more difficulties ingetting a handle on the forecast errors and the fragilityof the forecast.Close to 1000 financial institutions have shut down in2007 and 2008 from the underestimation of outsizedmarket moves, with losses up to 3.6 trillion
. Had theirmanagers been aware of the unreliability of theforecasting methods (which were already apparent inthe data), they would have requested a different risk profile, with more robustness in risk management andsmaller dependence on complex derivatives.
A- The Smoking Gun
We conducted a simple scientific examination of economic data, using a near-exhaustive set thatincludes 38 “tradable” variables
that allow for dailyprices: major equity indices across the globe (US,Europe, Asia, Latin America), most metals (gold, silver),major interest rate securities, main currencies –whatwe believe represents around 98% of tradable volume.We analyzed the properties of the logarithmic returnswhere
t can be 1 day, 10 days,or 66 days (non-overlapping intervals)
. A conventional test of nonnormality used in theliterature is the excess kurtosis over the normaldistribution. Thus we measured the fourth noncentralmoment of the distributions andfocused on the stability of the measurements.
Bloomberg, Feb 5, 2009.
We selected a set of near-exhaustive economic data thatincludes “tradable” securities that allow for a future or aforward market: most equity indices across the globe, mostmetals, most interest rate securities, most currencies. Wecollected all available traded futures data –what we believerepresents around 98% of tradable volume. The reason weselected tradable data is because of the certainty of thepractical aspect of a price on which one can transact: anontradable currency price can lend itself to all manner of manipulation. More precisely we selected “continuously rolled”futures in which the returns from holding a security are built-in. For instance analyses of Dow Jones that fail to account fordividend payments or analyses of currencies that do notinclude interest rates provide a bias in the measurement of themean and higher moments.
By convention we use t=1 as one business day.