THE FOURTH QUADRANT: A MAP OF THE LIMITS OF STATISTICS [9.15.08]
By Nassim Nicholas Taleb

An Edge Original Essay

Statistical and applied probabilistic knowledge is the core of knowledge; statistics is what tells you if something is true, false, or merely anecdotal; it is the "logic of science"; it is the instrument of risk-taking; it is the applied tools of epistemology; you can't be a modern intellectual and not think probabilistically—but... let's not be suckers. The problem is much more complicated than it seems to the casual, mechanistic user who picked it up in graduate school. Statistics can fool you. In fact it is fooling your government right now. It can even bankrupt the system (let's face it: use of probabilistic methods for the estimation of risks did just blow up the banking system).

The current subprime crisis has been doing wonders for the reception of any ideas about probability-driven claims in science, particularly in social science, economics, and "econometrics" (quantitative economics). Clearly, with current International Monetary Fund estimates of the costs of the 2007-2008 subprime crisis, the banking system seems to have lost more on risk taking (from the failures of quantitative risk management) than every penny banks ever earned taking risks. But it was easy to see from the past that the pilot did not have the qualifications to fly the plane and was using the wrong navigation tools: The same happened in 1983 with money center banks losing cumulatively every penny ever made, and in 1991-1992 when the Savings and Loans industry became history.

It appears that financial institutions earn money on transactions (say fees on your mother-in-law's checking account) and lose everything taking risks they don't understand. I want this to stop, and stop now— the current patching by the banking establishment worldwide is akin to using the same doctor to cure the patient when the doctor has a track record of systematically killing them. And this is not limited to banking—I generalize to an entire class of random variables that do not have the structure we thing they have, in which we can be suckers.

And we are beyond suckers: not only, for socio-economic and other nonlinear, complicated variables, we are riding in a bus driven a blindfolded driver, but we refuse to acknowledge it in spite of the evidence, which to me is a pathological problem with academia. After 1998, when a "Nobel-crowned" collection of people (and the crème de la crème of the financial economics establishment) blew up Long Term Capital Management, a hedge fund, because the "scientific" methods they used misestimated the role of the rare event, such methodologies and such claims on understanding risks of rare events should have been discredited. Yet the Fed helped their bailout and exposure to rare events (and model error) patently increased exponentially (as we can see from banks' swelling portfolios of derivatives that we do not understand).

Are we using models of uncertainty to produce certainties?

This masquerade does not seem to come from statisticians—but from the commoditized, "me-too" users of the products. Professional statisticians can be remarkably introspective and self-critical. Recently, the American Statistical Association had a special panel session on the "black swan" concept at the annual Joint Statistical Meeting in Denver last August. They insistently made a distinction between the "statisticians" (those who deal with the subject itself and design the tools and methods) and those in other fields who pick up statistical tools from textbooks without really understanding them. For them it is a problem with statistical education and half-baked expertise. Alas, this category of blind users includes regulators and risk managers, whom I accuse of creating more risk than they reduce.

more at: http://www.edge.org/3rd_culture/taleb08/taleb08_index.html

C'mon you guys, humor me! This is what I wrestle with for a living. Not in the financial world but in the natural world. In that context it applies directly to how we model systems like ... climate, for example.

B

From the title, who knew? My brain has been hurting from keeping up with all the market and election news, so I just ignored it. Sorry. I just read the posted text and my thoughts thus far are that (generally) we have been sold non existent stuff to greater degrees over time, and now we are trying to make it manifest. It ain't gonna work. Time to redefine reality. Time for real government leaders to step up to the plate and define the terms of the promises that can and should be kept and the ones that need to be revisited. I'll finish reading at the link soon.

__________________
-Marty

1986 300E 220,000 miles+ transmission impossible
(Now waiting under a bridge in order to become one)

Reading your M103 duty cycle:
http://www.peachparts.com/shopforum/showpost.php?p=831799&postcount=13
http://www.peachparts.com/shopforum/showpost.php?p=831807&postcount=14

I'm just self-righteously whining. It wont be the last time.

B

i like to think i'm like yogi (smarter than the average bear) but i lost him after "extremistan".

i do think everyone saw this coming (real estate wise) in southern california; but i just used a simple formula:

debt service (on home mortgage) > potential rent income

once you saw that - about 2003? 2004? - you knew that it all was going to fall apart.

will try and read the article again, i promise, ...cross my heart

__________________
"The law, in its majestic equality, forbids the rich as well as the poor to sleep under bridges, to beg in the streets, and to steal bread."

That's a hell of a paper. I've read it twice and I understand the implications of the science if not the science itself.

There is an hour long radio show at this link that tells the story from the perspective of the players, and describes the factors that contributed to the current credit crisis very well if anyone has the time to listen.

http://www.thisamericanlife.org/Radio_Episode.aspx?sched=1242

__________________
-Marty

1986 300E 220,000 miles+ transmission impossible
(Now waiting under a bridge in order to become one)

Reading your M103 duty cycle:
http://www.peachparts.com/shopforum/showpost.php?p=831799&postcount=13
http://www.peachparts.com/shopforum/showpost.php?p=831807&postcount=14

I know what you mean about implications of the science vs the science itself. I've been flailing about in it for around a year or so trying to get my mind around Bayesian statistics, with which Taleb's argument is enwrapped. I learned stats the old fashioned way -- 1 factor anovas and linear regression.

It is people educated like me, a small toolbox with only a hammer, that got us into the mess from the technical side. We didn't know enough to understand the fundamental dangers of market innovations like derivatives and hedge funds and the like. We are all wowed by the Nobel Prize winners and believe a prize is an indicator of infallibility.

Taleb understands the math, understands the underlying concepts and argues that it exposes us to unexpected events. Before all of these wonderful models came along investment bankers and stockbrokers were more conservative (in the financial sense) because they feared the unknown and so, faced the unknown with caution. With all of the modeling and such people self-deluded into supposing that they understood risk and therefore, discounted it. Taleb says we fundamentally do NOT understand risk and worse, the more we delude ourselves, the greater our exposure to disaster.

A lot of the econometric modeling is seeping into ecology. The terminology changes but the math remains much the same. It will be interesting to discover whether we succumb in ecology, to the unexpected because we believe we can control it. Right now most ecologists (scientists, not tree-huggers) are conservative (in the scientific sense!) because ecology is extremely complex and knowledge of dependencies and forcing factors is terribly inadequate. Ecology needs a Newton. But ecologists also need to remember that for every Newton, there's an Einstein. That's what economics needs -- it's Einstein.

Have you read "The Black Swan" by Taleb? I've read about half of it. You can borrow mine if you want.

__________________
You don't need a weatherman to know which way the wind blows - Robert A. Zimmerman

Yeah I read it. I read the first half like a hypnotized kid imitating a chicken.

The second half was kind of redundant and went slower. I recently read a review of the book in which the reviewer said Taleb's first book on much the same subject, was a lot better. The reviewer said he thought the publisher & Taleb were in a rush to capitalize on the 1st book's success. I definitely want to read his 1st book.

Not to say I didn't enjoy "Black Swan". I certainly did. I look forward to reading an even better version.

B

In the show I linked it seems that the borrowers, the brokers, and the dealers all knew, at least in some corner of their thought process, that there were big risks involved. But like Bernake, they chose to sight only examples that didn't discredit their choice to gamble. The motive was simple. If you win you gain big, if you lose you gain nothing, or in some cases, you still gain big. What no one considered at the market end of the lending was that the practice could kill the golden goose, or rather kill the market for golden eggs. The key to initiating the decision was the lure of the vast new pool of wealth that has recently appeared in the world as industrialization has spread. The only way to keep up with it's appetite for instruments was to relax the rules of lending to the point that, by the end, they were all cast aside save the signature. The real tragedy is that those bankers who 'knew better' 5 years earlier were convinced by circumstances to just say F it in the name of growth indexes. I wonder if the models would work better if the folks employing them were in a position to suffer the losses they indicate or fail to.

__________________
-Marty

1986 300E 220,000 miles+ transmission impossible
(Now waiting under a bridge in order to become one)

Reading your M103 duty cycle:
http://www.peachparts.com/shopforum/showpost.php?p=831799&postcount=13
http://www.peachparts.com/shopforum/showpost.php?p=831807&postcount=14

The greater my fiduciary responsibility, the less risk I'll take with your money.

That sure sounds like the key to me.

__________________
-Marty

1986 300E 220,000 miles+ transmission impossible
(Now waiting under a bridge in order to become one)

Reading your M103 duty cycle:
http://www.peachparts.com/shopforum/showpost.php?p=831799&postcount=13
http://www.peachparts.com/shopforum/showpost.php?p=831807&postcount=14

"Alex Blumberg: To help explain out what happened, here's my partner for this hour, Adam Davidson, the international business reporter for NPR. Hey Adam.
Adam Davidson: Hey Alex.
Alex Blumberg: So, I guess the first thing we have to talk about is the global pool of money, right?
Adam Davidson: Right. The global pool of money. That's where our story begins. Most people don’t think about it but there’s this huge pool of money out there, which is basically all the money the world is saving now. Insurance companies saving for a catastrophe, pension funds saving money for retirement, the central bank of England
saving for whatever central banks save for. All the world’s savings.

Ceyla Pazarbasioglu: It's a lot of money. It's about 70 trillion.

Adam Davidson: That is the head of capital market research at the International Monetary Fund, the place to go if you want know how much money is in the world.
Adam Davidson: How do we pronounce your name?
Ceyla Pazarbasioglu: That will take two minutes at least. It's Pazarbasioglu.
Adam Davidson: Pazarbasioglu.
Ceyla Pazarbasioglu. I'm very impressed.
Adam Davidson: And, by the way, before you finance enthusiasts start writing any letters, we do know that 70 trillion technically refers to that subset of global savings called fixed-income securities. Everyone else can just ignore what I just said. Let’s put 70 trillion dollars in perspective. Do this. Think about all the money that people
spend everywhere in the world. Everything you bought in the last year, all of it. Then add everything Bill Gates bought. And all the rice sold in China and that fleet of planes Boeing just sold to South Korea. All the money spent and earned in every country on earth in a year: that is LESS than 70 trillion, less than this global pool of money.
Alex Blumberg: Wow, that is a lot of money.
Adam Davidson: It is a lot of money. And that money comes with an army of very nervous men and women watching over the pool of money: investment managers. This army is nervous because they don't want to lose any of that money and they also want to make it grow bigger. But to make it grow, they have to find something
to invest in. So, for most of modern history, they bought really, really safe, really boring investments: things called treasuries and municipal bonds. Boring things. But then, right before our story starts, something changed, something happened to that global pool of money.

Ceyla Pazarbasioglu: This number doubled since 2000. In 2000 this was
about 36 trillion dollars.

Adam Davidson: So, it took several hundred years for the world to get to 36 trillion. Then, in six years, to get another 36 trillion.
Ceyla Pazarbasioglu: Yeah. There has been a very sharp increase.
Adam Davidson: How's the world get twice as much money to invest? Lots of things happened, but the main headline is all sorts of poor countries became kind of rich making TVs and selling us oil: China, India, Abu Dhabi, Saudi Arabia. Made a lot of money and banked it. China, for example, has over a trillion dollars in its central bank, and there are office buildings in Beijing filled with math geniuses-real math
geniuses-looking for a place to invest it. And the world was not ready for all this money. There's twice as much money looking for investments, but there are not twice as many good investments. So, that global army of investment managers was hungrier and twitchier than ever before. They all wanted the same thing: a nice low-risk investment that paid some return. But then something happened to make matters worse, at this precise moment, one guy took one of that army's favorite investments and made it a lot less attractive.

Alex Blumberg: So, this is where we have to talk about Alan Greenspan, right?
Adam Davidson: We have to.
Alex Blumberg: Alright. But I'm going to promise the people here that this is the last time you're going to hear Alan Greenspan in this story. So bear with us.
Adam Davidson: Here is one of his speeches that really drove that army of investment managers crazy.

Alan Greenspan: The FOMC stands prepared to maintain a highly
accommodative stance of policy for as long as needed to promote satisfactory economic performance.

Adam Davidson: You might not believe me, but that little statement: that is Central Banker speak for “Hey, global pool of money - screw you.”
Alex Blumberg: Come on, that’s not what he said
Adam Davidson: It is! I speak central banker and that’s what he’s saying. What he’s technically saying is he’s going to keep the Fed Funds rate at the absurdly low level of one percent. It tells every investor in the world: you are not going to make any money at all on US treasury bonds for a very long time. Go somewhere else. We can’t help you. And so the global pool of money looked around for some low-risk, high-return investment. And among the many things they put their money into, there was one thing they fell in love with. To get it, they called Wall Street - a guy like this:

Mike Francis: My name is Mike Francis. During the beginning of the mortgage implosion, I was an executive director at Morgan Stanley on the residential mortgage trading desk.

Adam Davidson: Mike was one link in a chain that connected the global pool of money to its new favorite investment, these residential mortgages, the US housing market, and guys like Clarence Nathan.
Think how attractive a mortgage loan is to that 70 trillion dollar pool of money. Remember, they're desperate to get any kind of interest return. They want to beat that miserable 1 percent interest Greenspan is offering them. And here are these homeowners, they're paying 5, 7, 9 percent to borrow money from some bank. So what if the global pool could get in on that action? ..."

__________________
-Marty

1986 300E 220,000 miles+ transmission impossible
(Now waiting under a bridge in order to become one)

Reading your M103 duty cycle:
http://www.peachparts.com/shopforum/showpost.php?p=831799&postcount=13
http://www.peachparts.com/shopforum/showpost.php?p=831807&postcount=14

I haven't worked with statistics for over 20 years but my recollection is that statistics can only base models on known behaviors. When the behaviors or the goals become irrational or are occluded then statistics fail to model accurately.

So a key component, it would seem, is to understand human nature when applied to groups and cross tab that with greed. Historically, as anyone who has studied the stock market will tell you, this combination is predictably unpredictable.

I have no knowledge with how this may apply to echo systems, unless greed is tantamount to a toxin entering the system. But I’m not sure greed is a toxin.

Greed is such a loaded word, being tied to sin and all, that I don't use it without definition.

What do you mean when you use that word?

B