Source: M.E.J. Newman(2005) and the author’s own calculations.
58
Clearly, you do not observe 100 percent in a finite sample.
59
This is a simple illustration of the general point of this book in finance and economics. If you do not believe in applying the bell curve to social variables, and if, like many professionals, you are already convinced that 'modern' financial theory is dangerous junk science, you can safely skip this chapter.
60
Granted, the Gaussian has been tinkered with, using such methods as complementary “jumps”, stress testing, regime switching, or the elaborate methods known as GARCH, but while these methods represent a good effort, they fail to address the bell curve’s fundamental flaws. Such methods are not scale-invariant. This, in my opinion, can explain the failures of sophisticated methods in real life as shown by the Makridakis competition.
61
More technically, remember my career as an option professional. Not only does an option on a very long shot benefit from Black Swans, but it benefits disproportionately from them – something Scholes and Merton’s “formula” misses. The option payoff is so powerful that you do not have to be right on the odds: you can be wrong on the probability, but get a monstrously large payoff. I’ve called this the “double bubble”: the overpricing of the probability and that of the payoff.
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I am selecting Merton because I found him very illustrative of academically stamped obscurantism. I discovered Merton’s shortcomings from an angry and threatening seven-page letter he sent me that gave me the impression that he was not too familiar with how we trade options, his very subject matter. He seemed to be under the impression that traders rely on “rigorous” economic theory – as if birds had to study (bad) engineering in order to fly.
63
Medieval medicine was also based on equilibrium ideas when it was top-down and similar to theology. Luckily its practitioners went out of business, as they could not compete with the bottom-up surgeons, ecologically driven former barbers who gained clinical experience, and after whom a-Platonic clinical science was born. If I am alive, today, it is because scholastic top-down medicine went out of business a few centuries ago.
64
I lost his business card, but would like to warmly thank a scientist traveling to Vienna aboard British Airways flight 700 on December 11, 2003, for suggesting the billiard ball illustration in Chapter 11. All I know about him is that he was fifty-two, gray-haired, English-born, wrote poetry on yellow notepads, and was traveling with seven suitcases since he was moving in with his thirty-five-year-old Viennese girlfriend.
65
It is impossible to go very deep into an idea when you run a business, no matter the number of hours the occupation entails – simply put, unless you are insensitive, the worries and feelings of responsibility occupy precious cognitive space. You may be able to study, meditate, and write if you are an employee, but not when you own a business – unless you are of an irresponsible nature. I thank my partner, Mark Spitznagel, for allowing me – thanks to the clarity of his mind and his highly systematic, highly disciplined, and well engineered approach – to gain exposure to high-impact rare events without my having to get directly involved in business activities.
