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MASTERING UNCERTAINTY
/WILD UNCERTAINTY
A focus on the exceptions
that prove the rule
Traditional risk management tools focus on what is normal and consider extreme events as ancillaries. In a world
characterised by volatility and uncertainty,
Benoit Mandelbrot
and
Nassim Taleb
argue that this approach is
misguided, and propose an alternative methodology where large deviations dominate the analysis
C
onventional
studies
of
uncer
tainty,
whether
in
statistics,
economics,
finance
or
social
science,
have
largely
stayed
close
to
the
socalled
“bell
curve”,
a
symmetrical
graph
that
represents
a
probability
distribution.
Used to great effect to describe errors in
astronomical measurement by the 19thcen
tury
mathematician
Carl
Friedrich
Gauss,
the bell curve, or Gaussian model, has since
pervaded our business and scientific culture,
and
terms
like
sigma,
variance,
standard
deviation, correlation, Rsquare and Sharpe
ratio are all directly linked to it.
If you read a mutual fund prospectus, or a
hedge fund’s exposure, the 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 that derive
from the bell curve and its kin.
Such measures of future uncertainty sat
isfy our ingrained desire to “simplify” by
squeezing into one single number matters
that are too rich to be described by it. In
addition, they cater to psychological biases
and our tendency to understate uncertainty
in order to provide an illusion of understand
ing the world.
The bell curve has been presented as “nor
mal” for almost two centuries, despite its
flaws being obvious to any practitioner with
empirical sense. Granted, it has been tink
ered with using such methods as comple
mentary
“jumps”,
stress
testing,
regime
switching or the elaborate methods known
as GARCH, but while they represent a good
effort, they fail to address the bell curve’s
fundamental flaws.
The
problem
is
that
measures
of
uncer
tainty using the bell curve simply disregard
the possibility of sharp jumps or discontinui
ties and, therefore, have no meaning or conse
quence. Using them is like focusing on the
grass and missing out on the (gigantic) trees.
In fact, while the occasional and unpredicta
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 Spring '09
 Taleb,NassimN

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