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Posted by Inya Ivkovic Mar 25, 2008 |
Taleb continues discussing rare events by introducing the example of Mexico’s so-called the “peso problem.” Namely, during the 1980s, economists were largely puzzled by certain Mexican variables, which behaved rather oddly, thus skewing their quantitative models. Constituting “odd behavior” were erratic switches between stable periods and volatile periods.
According to Taleb, “Rare events are always unexpected, otherwise they would not occur…They are generally caused by panics, themselves the results of liquidations (investors rushing to the door simultaneously by dumping anything they can put their hands on as fast as possible).”
Interestingly, the second edition of Fooled by Randomness was published in 2004. I’m mentioning this because even back then, Taleb talked about traders buying and hedging mortgage-backed securities within the context of rare and devastating events. Almost as if he had magical powers to predict the catastrophe that subprime lending crisis would have caused in the global markets today.
Part of the reason why rare events catch investors by surprise is their rather amazing “ability” to push “randomness under the rug.” Apparently, psychologists have found that people are generally more sensitive to the presence of a stimulus than to its actual magnitude. For example, if an investor loses a small amount of money, he is likely to be more upset about the mere fact that he did lose money than how much he had actually lost.
Taleb concludes the section saying, “In the markets, there is a category of traders for whom volatility is often a bearer of good news. These traders lose money frequently, but in small amounts, and make money rarely, but in large amounts. I call them crisis hunters. I am happy to be one of them.”
At this point, I have a felling I’m not the only one wishing to join the ranks of “crisis hunters.”