Taleb's Ludic Fallacy
Over at Traffick, there was a nice summary of some Nassim Taleb's thoughts on decision making and model, and one I particularly wanted to comment on - the Ludic Fallacy.
Beware the Ludic Fallacy. Author of The Black Swan: The Impact of the Highly Improbable and the preceding Fooled by Randomness, Nassim Nicholas Taleb tells a witty story about our tendency to trust heavily in the sanctity of models, if we're the type of people who were well schooled and trained to accept the assumptions 'inside the box.'An exercise is proposed to two individuals. The first, John, is a highly respected economist with a Ph.D. who has been working in a high-level analytical position with a bank for years. He has a variety of credentials including considerable training in advanced statistics. He dresses blandly and always makes his train on time. The other contestant, Fat Tony, is a street-smart property investor from Brooklyn, vaguely associated with mob financiers, who runs a couple of legitimate businesses. Taleb prefers to think of him as 'horizontally challenged Tony.'
The questioner (imagine Alex Trebek as host) says to both: 'Assume that this coin is not loaded or unbalanced in any way and that the outcome of a toss is completely random -that is, 50% of the time, a toss will come up heads, and 50% of the time, it will come up tails. Now, assume that the past 99 consecutive tosses have produced a result of 'tails.' What is the probability that the next coin toss will produce a result of 'tails'?'
'That's easy,' says Dr. John. '50%.'
'At least 99%,' counters Fat Tony. 'I don't care what you said. That coin's loaded. It can't be a fair game.' He then whispers a few insults about the 'nerds' he encountered in his 'bank days' - they 'just don't get it.'
The 'ludic fallacy' translates roughly as the 'nerd problem.' Archetypal nerds like bank risk analysts are unassailably 'right,' 'prudent,' and 'scientific' ... that is, until their model fails them. Caught inside our models, we only imagine catastrophic risks occurring within the parameters of our assumptions. It takes something completely outside the prefabricated 'game' to knock you off your horse. 'That wasn't supposed to happen' doesn't make a catastrophic event any less catastrophic.
What are we supposed to learn from this? Bet on Fat Tony because he a) is subject to the gambler's fallacy, but b) has a cooler name than Dr. John? Neither, I think.
But in reality this was wrong, and people were able to short triple-A securities very cheaply. They weren't paying a lot to be short and they made huge money on triple-A securities and triple-A CDO paper that now trades at fifty cents on the dollar. I mean that is like the water's not running today, right? The sun didn't rise.But if you were trained in finance, you probably are more likely to take for granted that, 'The rating agencies have a very sound process, credit analysis, the same process that I've been trained in, all the assumptions that I use are kind of the same as the assumptions they use.'
In the same fashion, if you assess the attractiveness of a trade based on historical data from a time when people weren't really actively doing that trade, and then suddenly everybody's doing that trade, the behavior of the trade will be different. And if you're trained the same way as everybody else, in general you're all going to behave the same. And when everyone behaves the same, that makes trades a lot riskier: everybody's buying at the same time, you get bubbles, everybody's selling at the same time, you get crashes.
There you have it: social proof causes both bubbles and crashes. And by the way, do you know how to really play the Monty Hall game?
