Sunday, January 18, 2009

Black swan and the laws of Mediocristan vs Extremistan

Nassim Nicholas Taleb, author of the bestselling book, The Black Swan, divides the world into 2 countries: Mediocristan and Extremistan. Looks like these two countries have completely different laws governing them. What are these laws? And how are they different? Let’s look at these questions in this article.

Mediocristan: Let’s start with Nassim’s favorite thought experiment. Assume that you round up a thousand people randomly selected from the general population and have them stand next to each other in one stadium. Imagine the heaviest person you can think of and add him to the sample. Assuming he weighs three times the average, between 400 and 500 pounds, he will represent a very small fraction of the total weight of the entire population (in this case about half a percent). In Mediocristan, when your sample is large, no single instance will significantly change the aggregate or the total. So who all belong to Mediocristan? Things like height, weight, income of a baker or a prostitute, car accidents, mortality rates, IQ etc.

Strange country of Extremistan: Now, let’s turn to the same people whom we lined up in a stadium and add up their net worth. Add to them net worth of Bill Gates which according to wikipedia is $58 billion. Now ask the same question: How much of the total wealth would he represent? 99.9 percent? Indeed, all others would represent no more than a rounding error for this net worth. For someone’s weight to represent such a share, he would need to weigh fifty million pounds! Same thing can be observed about book sales of randomly selected authors and adding J. K. Rowling to the list . In Extremistan, inequalities are such that one single observation can disproportionately impact aggregate, or the total. Nassim calls such events/things black swans. Matters that belong to Extremistan are: wealth, book sales per author, name recognition as a “celebrity”, speakers of a language, damage caused by earthquake, deaths in war, sizes of companies, financial markets etc.

How does this help? Nassim observes that the law of averages or the bell-curve statistics works well in Mediocristan. When friends from Mars will visit earth, they can check a small sample of people and learn a lot about people from Mediocristan. However, if you try to apply bell-curve to Extremistan it can get you in trouble. Let’s say you want to cross a river during your wildlife trek and you ask the local villager, “How deep is the river?” Villager says, “On an average 4 feet”. Now, in Extremistan, you don’t know whether it is: 4 feet +/- 1 foot or 4 feet and in one or two places 50 feet deep. Thanks to Satyam scam and the money I lost in a single day, I didn’t take time to understand what a black swan means. Next time you apply bell curve statistics to your decision (such as stock purchase), ask whether you are applying the right law in the right land.

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