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.

2012 Predictions Update

I’ve finally updated my predictions page for some of the predictions I made last year that can now be called.

I haven’t made new predictions for 2013 yet; I still need to take the time to do the analysis I want to make predictions I’m relatively sure of.

I learnt a few obvious things when reviewing my previous predictions. Although I’ve called all but one as “correct”, that included one where strictly speaking I would never be able to call it as true.

I said “MTN and Vodacom will never officially support bitcoins”. This can be called as false the moment they do support bitcoins, but can never truly be called as correct. However, I’ve called it as correct anyway. It’s become increasingly clear that bitcoins were the irrelevant fad I called them as being with more stories written about bitcoin fraud than anything else over the last year.

My most important prediction turned out to be incorrect. I predicted an increase in Italian bond yields or an exist of one country from the Euro. Italian, and particularly Spanish, bond yields did rise dangerously during the year. The ECB bent rules around directly financing nations through its support of secondary market bond prices. Technical acrobatics that circumvented the intentions of the founding fathers of the ECB, but also reflected the naivete of the founding thinking.

Different types of predictions

As part of the run-up to my overview of my own predictions for 2012, I thought i should highlight why I bother at all.
Most predictions, most of the time, will be wrong. Crystal balls aside, it is nearly impossible to reliably, accurately predict future complex events. However, the process of rigorously considering what might happen, what could go wrong, what the drivers of change are – all of those are really useful.
But why then bother making ultimate predictions if the “process” is where the value is? As it turns out, making the final prediction is part of the process. Paying poker without money at stake is a pointless exercise; there are no consequences to poor play (be it luck or skill that was lacking).
Making that firm and final prediction is important to ensure the process was rigorous and not an off the cuff guess.
Finally, evaluating part performance can’t suggest whether the predictions are improving, whether they are consistently biased or whether the system is working.
So, most predictions are wrong, but some are useful.

Prediction: Spanish yields to end week higher

This one is a mini prediction.  The sort of foolish short-term market movement calls that I think are usually such a waste of time.

But there is an angle here I’m exploring. Spanish yields have been climbing for months now on the very real risk of Euro breakup and Spanish default (at least in Euros). Yields were up to 7.6% last week before Draghi made a comment that the market believed meant they would buy Spanish bonds, as many and as often as necessary.

My take is that this is just one more in a long series of smoke screens without a real solution. The fire is still burning.  Spanish bond yields started the morning just below 6.8%. I’m fully expecting a further sell-off in bonds and yields to close Friday at above 6.8%.

Policy should include clear views on how it will be measured

This is getting ridiculous.  Shockingly bad policy is now being shown empirically to be shockingly bad. Only thing is, the policy proponents aren’t admitting they were wrong.

I get randomness. I understand that we don’t know exactly where the UK would be without austerity policies.  We don’t have a control group, there’s no clear comparison. But come on, the result is as predicted by those who said austerity was a bad idea and totally different from what proponents were claiming. Huge double dip recession at an accelerating rate in the UK.

So why isn’t their an admission and about-turn? Because no clear measure of how to measure the success of the policy were ever put into the public space. So now proponents can, and probably will, say how much worse it would have been without austerity.  Nonsense.

All major policy proposals should include an analysis of what the impact is expected to be with and without the policy, reviewed by credible, independent observers.  (Like the CBO in the US.)  Then, when the policies turn out to be rubbish, let’s haul out the predictions and see what was promised.


Prediction: US ten year yields will be below 7% up until 2016

Bloomberg story:

Vanguard Group Inc., whose $148.2 billion of Treasuries makes it the largest private owner of US debt, says the nation has until 2016 to contain its borrowings before bond investors revolt and drive up interest rates

The interesting thing here is that many people have said this would happen in 2009.  And 2010. And 2013. Vanguard is saying it will take 4 years.

I’m saying US interest rates won’t get to “unsustainable panic levels” taken, very loosely, by many to be 7% by 2016. I also don’t think it will happen for a while after then, but hey, there is an expanding funnel of doubt and I can’t predict everything that will happen.

I’m also not saying interest rates won’t increase between now and then at all.  Economic recovery in this period is possibly, at least to some extent, and this would result in higher interest rates through concerns around future inflation and an increase in short term rates that would give rise to reasonable expectations of higher short term rates in future.

My logic? The US borrows in its own currency.  The US still has a major economy.  Japan has had similar issues and is borrowing at incredibly low rates for 20 years of stagnation and ultra low inflation to deflation. There is a history here to learn from.

Prediction Update : US Yields stayed low

In August 2011 I predicted that, against cries of hyperinflation and debt crisis in the US, yields would stay low.

Specifically, I said:

Prediction: If the US debt is downgraded in the next 6 months, yields won’t increase by more than 0.2% 6 months after the downgrade. In other words, there might be a small, temporary uptick, but within 6 months yields will have returned to below 0.2% above the day before downgrade.

S&P downgraded the US a few days later on 5 August.  Yields on 10 year US bonds were 2.56%, Currently, US 10 year yields are just below 2.00%. Clearly, 6 months after the downgrade (and at every point in between) US yields have stayed low, well below the upper limit of my prediction.

If you were still listening to the “obviously” right concerns over high inflation from quantitative easing and relaxed monetary policy in the middle of a huge liquidity trap and massive reduction in private spending, it’s time to reset your views.