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Errors, robustness, and the fourth quadrant

  • Taleb, Nassim Nicholas
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    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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    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
    Contact details of provider: Web page: http://www.elsevier.com/locate/ijforecast

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