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Errors, robustness, and the fourth quadrant

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  • Taleb, Nassim Nicholas
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    Abstract

    The paper presents evidence that econometric techniques based on variance-L2 norm-are flawed and do not replicate. The result is un-computability of the role of tail events. The paper proposes a methodology to calibrate decisions to the degree (and computability) of forecast error. It classifies decision payoffs in two types: simple (true/false or binary) and complex (higher moments); and randomness into type-1 (thin tails) and type-2 (true fat tails), and shows the errors for the estimation of small probability payoffs for type 2 randomness. The fourth quadrant is where payoffs are complex with type-2 randomness. We propose solutions to mitigate the effect of the fourth quadrant, based on the nature of complex systems.

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    Bibliographic Info

    Article provided by Elsevier in its journal International Journal of Forecasting.

    Volume (Year): 25 (2009)
    Issue (Month): 4 (October)
    Pages: 744-759

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    Handle: RePEc:eee:intfor:v:25:y:2009:i:4:p:744-759

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    Web page: http://www.elsevier.com/locate/ijforecast

    Related research

    Keywords: Complexity Decision theory Fat tails Risk management;

    References

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    Cited by:
    1. Nassim N. Taleb & Raphael Douady, 2012. "Mathematical Definition, Mapping, and Detection of (Anti)Fragility," Papers 1208.1189, arXiv.org.
    2. David F. Hendry & Grayham E. Mizon, 2013. "Unpredictability in Economic Analysis, Econometric Modeling and Forecasting," Economics Papers 2013-W04, Economics Group, Nuffield College, University of Oxford.
    3. Taleb, Nassim N. & Tapiero, Charles S., 2010. "Risk externalities and too big to fail," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 389(17), pages 3503-3507.
    4. Nassim N. Taleb, 2012. "The Future Has Thicker Tails than the Past: Model Error As Branching Counterfactuals," Papers 1209.2298, arXiv.org.

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