How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud

July 5th, 2007

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Today, we will continue from How the folks in the finance/economics industry became turkeys?Part 1: Parable of the turkey and go deeper into the concept of the Bell curve. The ideas from this article comes from the book, The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb.Back in How the folks in the finance industry got the idea of ?risk? wrong!, we showed you the Bell curve:

The Bell curve

In Chapter 17 of his book, Nassim Nicholas Taleb, said that:

I only realised that Gaussian-trained [Bell curve-trained] finance professors were taking over business schools, and therefore MBA programs, and producing close to a hundred thousand students a year in the United States alone, all brainwashed by a phony portfolio theory. No empircal observation could halt the epidemic. It seemed better to teach students theory based on the Gaussian [Bell-curve] than to teach them no theory at all. It looked more ‘scientific’ than giving them what Robert C. Merton called the ‘anecdote.’

So the Gaussian [Bell curve] pervaded our business and scientific cultures, and terms such as sigma, variance, standard deviation, correlation, R square, and the eponymous Sharpe ratio, all directly linked to it, pervaded the lingo. If you read a mutual fund prospectus, or a description of a hedge fund’s exposure, odds are that it will supply you, among other information, with some quantitative summary claiming to measure ‘risk.’ That measure will be based on one of the above buzzwords derived from the bell curve and its kin. Today, for instance, pension funds’ investment policy and choice of funds are vetted by ‘consultants’ who rely on portfolio theory. If there is a problem, they can claim that they relied on standard scientific method.

So, what is the idea behind the Bell curve?

Bell curve simply means that things revert to the mean in the long run. Also, as you deviate further and further away from the mean, the probability of that deviation will drop faster and faster. Therefore, by the definition of the Bell curve, extreme deviation from the mean is extremely unlikely, so much so that it is close to impossible.

The problem with mainstream thinking in today’s finance and economics industry is that the Bell curve is their cornerstone assumption. In other words, the Bell curve assumption is used extensively to model reality and derive conclusions and forecasts. Take that assumption away and all that is left is nothing but hot air, which is a devastating threat to the countless professions, businesses and vested interest of those in these industries!

Very unfortunately, it is obvious even from just a casual observation of the world around you, the universe is often not ruled by the Bell curve. Extreme events occur frequently, which by definition of the Bell curve is close to impossibility. For example, as the book says,

If the world of finance were Gaussian [Bell curve], an episode such as the [1987] crash (more than twenty standard deviations) would take place every several billion lifetimes of the universe.

A quick look at the stock market history will show you that crashes do happen many times in the past century. Extreme events often do happen. Extreme wealth and poverty exists. We do not live in a world where everything reverts strongly to the mean. The Bell curve is an atrocious tool to model the world.

Yet, the finance and economics industry uses them as if they are the gospel truth. What is the consequences of all these? We will talk more about it in the next article of this series.