Friday, December 19, 2008

Fooled By Randomness: Chapters 7 and 8

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

The problem of induction may be phrased as follows: “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.”

Recognize that inductive reasoning (statistics) is not perfect. Use it to make decisions, but do not use it to manage risks and exposure!!

The survivorship bias, as discussed earlier is the failure to consider those that followed the same path as the people we are analyzing, but failed to reach the same success (or be successful at all). It is extremely difficult to view these people, since history does not record them. To correct for this bias, we may want to adjust the success of those we are considering to take into account the effect of those that failed to survive.

We tend to mistake one realization among all possible random histories as the most representative one, forgetting that there may be others… The survivorship bias implies that the highest performing realization will be the most visible. Why? Because the losers do not show up.

Conclusion: Taleb’s point is that survivorship bias is a chronic syndrome affecting most people. We naturally ignore the data we do not see, so we must work hard to counter survivorship bias.

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