Can't get away from Taleb.
The fourth quadrant is where the difference between absence of evidence and evidence of absence becomes acute. It is where Extremistan mixes with Complexity, aka the Black Swan domain.
He says the most obvious way to exit the fourth quadrant is by "truncating," cutting certain exposures by purchasing insurance, when available, and by putting oneself in a barbell situation, ie. take small amount of big risk and a large amount of little or no risk.
Rules to Increase Robustness
(1) Have respect for time and nondemonstrative knowledge.
(2) Avoid optimization; learn to love redundancy*.
(3) Avoid prediction of small probability payoffs - though not necessarily of ordinary ones.
(4) Beware of "atypicality" of remote events**.
(5) Beware moral hazard with bonus payments***.
(6) Avoid some metrics****.
(7) Positive or negative Black Swan.
(8) Do not confuse absence of volatility with absence of risk.
(9) Beware presentations of risk numbers.
*Redundancy in the financial realm is lots of cash under the mattress. Cash is the opposite of debt.
**This relates to the assumptions underlying MPT and the non-stationarity of the data. He calls scenario analysis and stress testing "sucker methods" because they are based on the past (which is not necessarily a good guide to the future).
***Akin to the asset liability mismatch in banking is the timing mismatch between bonus' paid for short term performance when risks and ultimate demise are increasing over time (moral hazard).
****Conventional metrics (std deviation, linear regression, etc.) based on an assumption of Mediocristan don't apply to the fourth quadrant (Extremistan). The evolution into Extremistan is marked by lowering volatility. Risk perception is subject to framing issues that are acute in the fourth quadrant.
Showing posts with label fourth quadrant. Show all posts
Showing posts with label fourth quadrant. Show all posts
Saturday, January 19, 2013
Iatrogenics - The Study of Harm Caused by the Healer
More Taleb.
He applies the principle of iatrogenics to regulation and the regulatory response to crisis, and I tend to agree. He says, you cannot do anything with knowledge unless you know where it stops, and the cost of using it. The call for more (unconditional) regulation of economic activity appears to be a normal response to crisis.
The problem with regulation in my mind is that it tends to only add to the existing body of regulation, when in fact what he is saying is the solution may require either less regulation or the addition of new regulations in conjunction with the stripping away of old regulations.
Given that we only "look through the glass darkly" ie. don't know the whole truth, and given the political systems and institutions in place, we are prone to only add new regulation when a problem arises.
Ultimately, the weight of an over-regulated edifice will come toppling down and we will break it all down and rebuild from scratch again.
He applies the principle of iatrogenics to regulation and the regulatory response to crisis, and I tend to agree. He says, you cannot do anything with knowledge unless you know where it stops, and the cost of using it. The call for more (unconditional) regulation of economic activity appears to be a normal response to crisis.
The problem with regulation in my mind is that it tends to only add to the existing body of regulation, when in fact what he is saying is the solution may require either less regulation or the addition of new regulations in conjunction with the stripping away of old regulations.
Given that we only "look through the glass darkly" ie. don't know the whole truth, and given the political systems and institutions in place, we are prone to only add new regulation when a problem arises.
Ultimately, the weight of an over-regulated edifice will come toppling down and we will break it all down and rebuild from scratch again.
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