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Errors, robustness, and the fourth quadrant

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  • Taleb, Nassim Nicholas

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.

Suggested Citation

  • Taleb, Nassim Nicholas, 2009. "Errors, robustness, and the fourth quadrant," International Journal of Forecasting, Elsevier, vol. 25(4), pages 744-759, October.
  • Handle: RePEc:eee:intfor:v:25:y:2009:i:4:p:744-759
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    References listed on IDEAS

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    Cited by:

    1. N. N. Taleb & R. Douady, 2013. "Mathematical definition, mapping, and detection of (anti)fragility," Quantitative Finance, Taylor & Francis Journals, vol. 13(11), pages 1677-1689, November.
    2. Hendry, David F. & Mizon, Grayham E., 2014. "Unpredictability in economic analysis, econometric modeling and forecasting," Journal of Econometrics, Elsevier, vol. 182(1), pages 186-195.
    3. Samiul Hasan & Greg Foliente, 2015. "Modeling infrastructure system interdependencies and socioeconomic impacts of failure in extreme events: emerging R&D challenges," Natural Hazards: Journal of the International Society for the Prevention and Mitigation of Natural Hazards, Springer;International Society for the Prevention and Mitigation of Natural Hazards, vol. 78(3), pages 2143-2168, September.
    4. Nassim N. Taleb, 2012. "The Future Has Thicker Tails than the Past: Model Error As Branching Counterfactuals," Papers 1209.2298, arXiv.org.
    5. Hendry, David F. & Mizon, Grayham E., 2014. "Unpredictability in economic analysis, econometric modeling and forecasting," Journal of Econometrics, Elsevier, vol. 182(1), pages 186-195.

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    Keywords

    Complexity Decision theory Fat tails Risk management;

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