How the folks in the finance/economics industry became turkeys?Part 3: Consequences of turkey thinking

July 12th, 2007

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Back in our earlier article, How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud, we said that:

Yet, the finance and economics industry uses them [Bell curve] 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.

To understand the consequences, we first have to understand the importance of an event. With a correct understanding of its importance, we can then allocate our priorities to prepare for it. There are two components in deciding how important an event is:

  1. Probability of it happening
  2. Impact it will cause when it happens

Therefore, the importance of an event is the probability of it happening multiplied by its impact when it happens. For example, while it is probably very unlikely for another hurricane that is worse than Katrina to strike again, the consequences, should it happen, is very devastating. Therefore, it is important to prepare for it. This is the very definition of the Black Swan event?an event that is highly improbable but having colossal impact (either good or bad).

The problem with many in the finance and economics industry is that through the use of the Bell curve, the probabilities of Black Swan events happening become severely underestimated. As a result, some risks are wrongly deemed to be extremely unlikely and thus, there are completely no preparations for them.

That is the difference between the mainstream and us. We do prepare for Black Swans.