Monday, March 14, 2005

Fat Tails, poker and finance

The idea of fat tails is statistical imagery. A standard bell shaped curve is used to describe all sorts of data. The problem with standard descriptions is they don't normally represent reality. Reality is messy, math quants like things that are smooth. Look at the bell and it always seems to taper to nice, thin, end points. Plot out any data stream and there will be "outliers " that don't fit the chart. The smoothing removes these weird elements and renders a nice, predictable result. It is an outlier that kills by surprise, waiting in a gully with a high powered riffle to "dry gulch" a passerby. Whenever a statistician says something will only happen every 50 years, they have probably smoothed the data, and it may hit before the day is out. A financial company, Long Term Capitol Management (LTCM), almost brought down the world financial system a few years back. It seems that items that only can happen, oh once every few thousand years, can happen within a few years of founding your company. LTCM had two Nobel economists among it's founders and guiding lights. Oops. Bad beats at poker, where you are all in and a novice hits that 2 outer on the river. Those happen more often then they should, to you. Poker has fat tails, and unlike finance, there is no way to hedge, except to play a lot of hands at limits you can afford.

Next blog will probably be:

Gamblers call it variance, finance quants call it gambler's ruin.

Maybe after that we will try:

life is not linear

P.S. I'm always in a hurry, don't expect perfection here. Do let me know if you spot even a minor flaw at my web sites. Gotta keep them clean. Thanks

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