Binary vs “vanilla” bets and hedging

Nassim Taleb, an author who usually inspires (except in his second book, Black Swans) has co-authored a paper with a long-tailed title “On the Difference between Binary Prediction and True Exposure with Implications for Forecasting Tournaments and Decision Making Research”.

The paper isn’t paygated so check it out – it’s only 6 pages so definitely accessible. Don’t worry about the couple of typos in the paper, bizarre as it may be to find them in a paper that presumably was reviewed, the ideas are still good.

The key idea is that prediction markets usually focus on binary events. Will Person Y win the election? Will China invade Taiwan? These outcomes are relatively easy to predict and circumvent important challenges of extreme outcomes and Taleb’s Black Swans.

A quote from the paper, itself quoting Taleb’s book, Fooled By Randomness, sums up the problem of trying to live in. Binary world when the real world has a wide range of outcomes.

In Fooled by Randomness, the narrator is asked “do you predict that the market is going up or down?” “Up”, he said, with confidence. Then the questioner got angry when he discovered that the narrator was short the market, i.e., would benefit from the market going down. The trader had a difficulty conveying the idea that someone could hold the belief that the market had a higher probability of going up, but that, should it go down, it would go down a lot. So the rational response was to be short.