The field of statistics is based on something called the law of large numbers: as you increase your sample size, no single observation is going to hurt you. Sometimes that works. But the rules are based on classes of distribution that don’t always hold in our world.
All statistics come from games. But our world doesn’t resemble games. We don’t have dice that can deliver. Instead of dice with one through six, the real world can have one through five—and then a trillion. The real world can do that.
That’s why portfolio theory simply doesn’t work. It uses metrics like variance to describe risk, while most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk. It’s very foolish to use variance.
Author: Nassim Nicholas Taleb
Source: “McKinsey Quarterly”
Subjects: Finance, Risk Management, Statistics
Click to Add the First »