GoldenTiger
03-23-2003, 01:12 AM
TEN-SIGMA
Part 1: Introduction
by Jim Puplava
Where do I begin?
How do you write about something that has not yet happened? How do you write about something that is out of the ordinary and lies hidden in the realm of the unexpected? We live in uncertain times and at a point in history where the world is craving normality. What this 21st Century world craves does not exist. Normal has in fact become abnormal.
The risks that now surround us are much bigger and more prevalent than once thought. At the same time, they are much harder to isolate and pin down. Although we are taught that most probabilities should occur within the normal standard deviations, it seems our world today is experiencing extreme events that occur more frequently than theories would suggest. Present day financial models and political risk scenarios have ruled out of existence a ten standard deviation event or what is called "ten-sigma." No radar screen or satellite image has been developed to detect their whereabouts or where they will strike next. And yet, the likelihood of a ten-sigma event's occurrence grows greater by the day.
Since most models have ruled out their existence, few precautions have been taken and few life preservers and lifeboats are at hand. The captains of the financial industry, the central bankers that control the flow of credit, the politicians that lead nations, and the generals that direct armies have confined all risk to linear probabilities that have been wedded to normal bell-shaped curves. It is the outliers or the tail ends of the curve that should concern us.
We live in the 21st century, yet our models are based on the continuity of the past. Since risk assessment can be subjective, those who manage risk can only guess at what may unfold based on known data from the past. We live, and to some extent, hide behind models that remove risks out of the equation. It is widely accepted that through mathematical modeling, all risks can be removed and hedged out of existence. In the process, a perfect bell-shaped curve is created which marginalizes tail risks to the realm of the remote, insignificant and improbable.
Today, Wall Street operates on the non-fictional assumption of mathematical certainty. In the real world, no such certainty exists. Every trading floor, trading system and computer screen has been programmed with the assumption that all models are reliable and predictive about the future. The possibility that markets or political events could depart from the norm would be considered a statistical aberration. In the real world, patterns are constantly changing and emerge out of the chaotic disorder of numerous random events. Only through the passage of time do continuities begin to emerge, and then if only for a brief period.
It's All In The Toss Of A Coin
Problems emerge when continuities are embedded in models that give the illusion of a perfect, risk-free state of balance. But all models have flaws. One can never assume that the samples of data on which they are based can ever be complete. The theories of randomness lack codification of previous events. Each new coin flip is apt to be different from the previous toss. The fact that heads have shown up three times in a row doesn’t mean the next coin toss will be the same. The odds on the next coin toss still remain fifty-fifty. Just because heads have appeared more frequently doesn’t exclude the next toss from showing up as tails.
Financial and political risk models are subject to more discontinuous events than is willingly admitted. That is why when tails show up, the world is taken by surprise. The tail toss shows up as an aberration only because the models are programmed to predict heads. That is why when a tail emerges, it leaps off the charts because charts can't predict them. When in fact they do occur, they are labeled as "The Hundred-Year Storm, "The Five Hundred-Year Storm," or if unexpected and extreme, “The Perfect Storm.”
On Wall Street, risk has been confined to volatility around the mean. Volatility has become "The Holy Grail” of modern finance. The quants believe they are protected by their models. In the fundamental camp, risk managers rely on financial statements and the ability to predict the future from the past. Technicians hold on to their charts as if the closing price printed at the end of each day is a reliable predictor of the future. In my opinion, ten-sigma events exist outside the realm of reality in all three camps.
To understand the future, we must learn to think three-dimensionally—and more importantly—outside the box. It is inconceivable to most on Wall Street, London, Bonn, Paris or Tokyo that some unforeseen event or rogue wave can capsize the whole ship. The simple fact that the ship has not capsized in the past doesn’t guarantee that an unexpected rogue wave can't suddenly appear and sink it. Rogue waves have a habit of appearing out of nowhere, without warning, and at a time you least expect.
Sailors have long known where and when to expect rogue waves and to prepare for them. When the barometer drops suddenly or when weather forecasters call for a Beaufort scale wind force of 10 to 12, sailors immediately take protective action. If out at sea and the Beaufort scale rises to 4 to 5, sail area is shortened to reduce heeling and keep the boat under control. Beaufort scale storms of 7 to 8 mean boats remain in harbor. If at sea, sailors batten down the hatches. If the Beaufort scale rises to 10 to12, there are few options outside prayer.
Rest of story ...http://www.financialsense.com/stormwatch/update.htm
Part 1: Introduction
by Jim Puplava
Where do I begin?
How do you write about something that has not yet happened? How do you write about something that is out of the ordinary and lies hidden in the realm of the unexpected? We live in uncertain times and at a point in history where the world is craving normality. What this 21st Century world craves does not exist. Normal has in fact become abnormal.
The risks that now surround us are much bigger and more prevalent than once thought. At the same time, they are much harder to isolate and pin down. Although we are taught that most probabilities should occur within the normal standard deviations, it seems our world today is experiencing extreme events that occur more frequently than theories would suggest. Present day financial models and political risk scenarios have ruled out of existence a ten standard deviation event or what is called "ten-sigma." No radar screen or satellite image has been developed to detect their whereabouts or where they will strike next. And yet, the likelihood of a ten-sigma event's occurrence grows greater by the day.
Since most models have ruled out their existence, few precautions have been taken and few life preservers and lifeboats are at hand. The captains of the financial industry, the central bankers that control the flow of credit, the politicians that lead nations, and the generals that direct armies have confined all risk to linear probabilities that have been wedded to normal bell-shaped curves. It is the outliers or the tail ends of the curve that should concern us.
We live in the 21st century, yet our models are based on the continuity of the past. Since risk assessment can be subjective, those who manage risk can only guess at what may unfold based on known data from the past. We live, and to some extent, hide behind models that remove risks out of the equation. It is widely accepted that through mathematical modeling, all risks can be removed and hedged out of existence. In the process, a perfect bell-shaped curve is created which marginalizes tail risks to the realm of the remote, insignificant and improbable.
Today, Wall Street operates on the non-fictional assumption of mathematical certainty. In the real world, no such certainty exists. Every trading floor, trading system and computer screen has been programmed with the assumption that all models are reliable and predictive about the future. The possibility that markets or political events could depart from the norm would be considered a statistical aberration. In the real world, patterns are constantly changing and emerge out of the chaotic disorder of numerous random events. Only through the passage of time do continuities begin to emerge, and then if only for a brief period.
It's All In The Toss Of A Coin
Problems emerge when continuities are embedded in models that give the illusion of a perfect, risk-free state of balance. But all models have flaws. One can never assume that the samples of data on which they are based can ever be complete. The theories of randomness lack codification of previous events. Each new coin flip is apt to be different from the previous toss. The fact that heads have shown up three times in a row doesn’t mean the next coin toss will be the same. The odds on the next coin toss still remain fifty-fifty. Just because heads have appeared more frequently doesn’t exclude the next toss from showing up as tails.
Financial and political risk models are subject to more discontinuous events than is willingly admitted. That is why when tails show up, the world is taken by surprise. The tail toss shows up as an aberration only because the models are programmed to predict heads. That is why when a tail emerges, it leaps off the charts because charts can't predict them. When in fact they do occur, they are labeled as "The Hundred-Year Storm, "The Five Hundred-Year Storm," or if unexpected and extreme, “The Perfect Storm.”
On Wall Street, risk has been confined to volatility around the mean. Volatility has become "The Holy Grail” of modern finance. The quants believe they are protected by their models. In the fundamental camp, risk managers rely on financial statements and the ability to predict the future from the past. Technicians hold on to their charts as if the closing price printed at the end of each day is a reliable predictor of the future. In my opinion, ten-sigma events exist outside the realm of reality in all three camps.
To understand the future, we must learn to think three-dimensionally—and more importantly—outside the box. It is inconceivable to most on Wall Street, London, Bonn, Paris or Tokyo that some unforeseen event or rogue wave can capsize the whole ship. The simple fact that the ship has not capsized in the past doesn’t guarantee that an unexpected rogue wave can't suddenly appear and sink it. Rogue waves have a habit of appearing out of nowhere, without warning, and at a time you least expect.
Sailors have long known where and when to expect rogue waves and to prepare for them. When the barometer drops suddenly or when weather forecasters call for a Beaufort scale wind force of 10 to 12, sailors immediately take protective action. If out at sea and the Beaufort scale rises to 4 to 5, sail area is shortened to reduce heeling and keep the boat under control. Beaufort scale storms of 7 to 8 mean boats remain in harbor. If at sea, sailors batten down the hatches. If the Beaufort scale rises to 10 to12, there are few options outside prayer.
Rest of story ...http://www.financialsense.com/stormwatch/update.htm