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The Relevancy of Probability in Economics

February 13, 2018

THE RELEVANCY OF PROBABILITY IN ECONOMICS

Modern economics in addition to sophisticated mathematics also employs probability distributions. What is probability?  The probability of an event is the proportion of times the event happens out of a large number of trials.

For instance, the probability of obtaining heads when a coin is tossed is 0.5. This does not mean that when a coin is tossed 10 times, five heads are always obtained.

However, if the experiment is repeated a large number of times then it is likely that 50% will be obtained. The greater the number of throws, the nearer the approximation is likely to be.

Alternatively, say it has been established that in a particular area, the probability of wooden houses catching fire is 0.01. This means that on the basis of experience, on average, 1% of wooden houses will catch fire.

This does not mean that this year or the following year the percentage of houses catching fire will be exactly 1%. The percentage might be 1% or not each year. However, over time, the average of these percentages will be 1%.

This information, in turn, can be converted into the cost of fire damage, thereby establishing the case for insuring against the risk of fire. Owners of wooden houses might decide to spread the risk by setting up a fund.

Every owner of a wooden house will contribute a certain proportion to the total amount of money that is required in order to cover the damages of those owners whose houses are going to be damaged by the fire.

Note that insurance against fire risk can only take place because we know its probability distribution and because there are enough owners of wooden houses to spread the cost of fire damage among them so that the premium is not going to be excessive.

 

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Have you prepped for the most likely SHTF event?

April 23, 2017

Have you prepped for the most likely SHTF event?

I like to read a lot of self-reliant and prepping blogs and articles, as we all likely do. Toward the beginning of my self-reliant venture, these articles and blogs were critical in my education. I am in no way an expert in this field, but I am comfortable enough that a lot of this information for me now is review, and it is always good to review the basics.

I love reading articles and blogs simply for the fact that there is usually more than one way to skin the proverbial cat, and I’m always looking for ways to improve my knowledge base or tweak existing techniques. This self-reliant community is often very willing to share their experiences, both positive and negative, so that others may learn from their successes as well as their failures. To say this community is rich in comradery would be an understatement, to say the least.

I have never written for another blog other than my own, so this is a new venture for me. I hope I will be able to give something back to someone here and return the favor that you have all given me over the last several years.

As I continue to read and search the self-reliant and prepper communities, I run across multiple hits regarding making fire, storing and gathering water, weapons and ammunition, just to name a few. It’s not that these things aren’t important, they should be the staple of anyone’s self-reliant plan, however there is one particular aspect that I rarely see mentioned, and yet it is likely one of the most commonly overlooked ways to prepare for bad times ahead.

 

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Uncertainty and the Humility of Forecasting an Unknowable Future

April 5, 2017

Uncertainty and the Humility of Forecasting an Unknowable Future

While we’re being reassured that all these grandiose promises are resting on trends that are as reliably predictable as the tides, the next easily predictable crisis will very likely reveal the trends are speculative bubbles that will predictably burst in a devastating reversion.

Certainty and uncertainty come in a variety of flavors. “Certainty” seems rather definite, but lurking beneath certainty is the more scientifically verifiable notion of probability: the probability of outcomes can be high enough to qualify as certain and low enough to qualify as unlikely.

We can’t know with perfect certainty that our neighbor hasn’t invented a death-ray and may decide to test it on us due to that simmering feud over his dog Fluffy’s antics on our yard.

But we can make an assessment of the probability of this occurring, and conclude the probability is low with a high degree of certainty.

This assessment should change, of course, if we hear strange noises in his shop and notice shrubs in his back yard are now charred in peculiarly symmetric circles–and we learn he previously worked at a national lab on high-energy weapons but was dismissed for pursuing crazy ideas about developing handheld death-ray devices, i.e. phasers. (Star Trek fans, please raise a cheer.)

This brings us to a critical distinction between low-probability events, i.e. known unknowns a.k.a. highly unlikely “long-tail” events, and unknown unknowns, a.k.a. “black swans” made famous by author Nassim Taleb.

What is a known unknown? Death qualifies as a known unknown: we know with a high degree of certainty that the vast majority of living things eventually die (even cancer cells die once their host dies)–but the timing of their individual natural death is inherently uncertain, due to the great number of inputs, variables and causal factors intrinsic to life.

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Honey, I Broke the Markets

December 17, 2015

Honey, I Broke the Markets

“Donald Trump looks like the villain in a movie where the hero is a dog.”

– The internet.

Which four letter word still has an amazing capacity to cause offence, anxiety and aggravation ? In the world of investment, that word would have to be
R-I-S-K.

Do we even have a workable definition of what it means ?

Author Guy Fraser-Sampson, in ‘The Pillars of Finance’, points out that before the Second World War, financial thinkers had a somewhat humbler perspective on the subject:

“..while before the War there was eager discussion as to what risk might be, and whether it was the same thing as uncertainty, there was total agreement that whatever it was it was probably too complex an animal ever to be fully understood and, in particular, that it was incapable of mathematical calculation.” [Emphasis ours.]

The American academic Frank Knight published ‘Risk, Uncertainty and Profit’ in 1921. As he wrote, some forms of uncertainty are measurable. There is, for example, empirical observation with regard to the occurrence of a number of discrete outcomes, such as the rolling of dice.

Then there is ‘true uncertainty’, such as the chances of a house in a particular area catching fire in any given year. The probability of dice throws is capable of mathematical calculation – albeit the outcome is still not guaranteed – whereas the chance of a house burning down is not. In relation to fire insurance, we can only use statistical inferences drawn from prior observation.

“The import of this distinction.. is that the first.. type of probability is practically never met with in business, while the second is extremely common. It is difficult to think of a business ‘hazard’ with regard to which it is any degree possible to calculate in advance the proportion of distribution among the different possible outcomes. This must be dealt with, if at all, by tabulating the results of experience. The ‘if at all’ is an important reservation.”

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charles hugh smith-The Oil-Drenched Black Swan, Part 1

December 1, 2014

charles hugh smith-The Oil-Drenched Black Swan, Part 1.

Given the presumed 17% expansion of the global economy since 2009, the tiny increases in production could not possibly flood the world in oil unless demand has cratered.

The term Black Swan shows up in all sorts of discussions, but what does it actually mean? Though the term has roots stretching back to the 16th century, today it refers to author Nassim Taleb’s meaning as defined in his books, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets and The Black Swan: The Impact of the Highly Improbable:

“First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme ‘impact’. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.”

Simply put, black swans areundirected and unpredicted. The Wikipedia entry lists three criteria based on Taleb’s work:

1. The event is a surprise (to the observer).

2. The event has a major effect.

3. After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected; that is, the relevant data were available but unaccounted for in risk mitigation programs.

It is my contention that the recent free-fall in the price of oil qualifies as a financial Black Swan. Let’s go through the criteria:

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