Mar

1

 I read and hear many people saying 'what a waste' today about the tsunami precautions in Hawaii. It reveals an interesting thought pattern that is a trap for traders and everyone confronted with imperfect prediction systems.

Are insurance premiums a waste? Is that fire extinguisher a waste? Doubt it, provided you did not overpay. We call this the Rule of 1. The Rule of 1 = the number of times a model (or modeler) can be wrong before people stop believing them.

Human brains have a horrible built-in concept of probability. We reward single successes and punish single failures when we should not. One day of good or bad luck tells little. Just because you did not die this month doesn't mean you can cancel the term life insurance for next month, which you originally bought to provide for your wife and kids in case you did die.

Traders need to estimate risk and act on that estimate, not ignore risk. No such thing as a perfect model. It (and you) will be wrong from time to time no matter how good it is (or you are). Frame the thinking as "What is the cost of the risk if it happens?" Heading for the hills after a huge earthquake is cheap insurance. The cost is of the risk is dying. A bad trade to stay on the beach. The beach will be there tomorrow. Other bad trades or too much leverage can cost you all your capital. The market will be there tomorrow, too.

Another rule for the reader. The Rule of 3. Suppose you test or look for something multiple times and do not find it. Can you estimate the probability it is there, even if you did not see it when you looked n times? The textbook example is: suppose you are told you need a serious and difficult to perform operation, and you are told the surgeon has performed the operation 20 times and no one died. What is the chance you will die? The Rule of 3 states that the 95% upper bound for no events is 3/n. So you still have a 3/20 or 15% chance of dying if you have the operation. (Van Belle, Statistical Rules of Thumb, 1st ed, pages 49-50)


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