Difference between Binary Prediction and True Exposure, with Implications for Forecasting Tournaments and Prediction Markets: Taleb

Binary prediction:  There are serious differences between predictions, bets, and exposures that have a yes/no type of payoff, the “binaries”, and those that have varying payoffs, which we call the “vanilla”. Real world exposures tend to belong to the vanilla category, and are poorly captured by binaries. Vanilla exposures are sensitive to Black Swan effects, model errors, and prediction problems, while the binaries are largely immune to them. The binaries are mathematically tractable, while the vanilla are much less so.  Hedging vanilla exposures with binary bets can be disastrous–and because of the human tendency to engage in attribute substitution when confronted by difficult questions, decision-makers and researchers often confuse the vanilla for the binary.

Difference between Binary Prediction and True Exposure, with Implications for Forecasting Tournaments and Prediction Markets: Taleb

Binary Predictions vs Vanilla Predictions

Binary: Binary predictions are about well defined discrete events, such as whether a person will win the election, a single individual will die, a team will win a contest. We call them binary because the outcome is either 0 (the event does not take place) or 1 (the event took place). You cannot have five hundred people winning a presidential election.

Vanilla: “Vanilla” predictions, also known as natural exposures, correspond to situations in which the payoff is continuous and can take several values. The “vanilla” designation comes from option exposures that are open-ended as opposed to the binary ones that are called “exotic”. The designation “vanilla” is fitting outside option trading because the exposures they designate are naturally occurring continuous variables, as opposed to the binary that which tend to involve abrupt institution-mandated discontinuities. The vanilla add a layer of complication: profits for companies or deaths due to terrorism or war can take many, many potential values. You can predict the company will be “profitable”, but the profit could be $1 or 10 billion.

Most of the variables affecting the vanilla are not bounded, or have a remote boundary. So the prediction of the vanilla is marred by Black Swan effects. A few prescient observers saw the potential for war among the Great Power of Europe in the early 20th century but virtually everyone missed the second dimension: that the war would wind up killing an unprecedented twenty million persons, setting the stage for both Soviet communism and German fascism and a war that would claim an additional 60 million, followed by a nuclear arms race from 1945 to the present, which might some day claim 600 million lives.

Binary predictions via

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2284964

H/T ValueInvestingWorld

LEAVE A COMMENT


Saved Articles
X
TextTExtLInkTextTExtLInk

The Life and Career of Charlie Munger

Charlie is more than just Warren Buffett’s friend and Berkshire Hathaway’s Vice Chairman – Buffett has actually credited him with redefining how he looks at investing. Now you can learn from Charlie firsthand via this incredible ebook and over a dozen other famous investor studies by signing up below:

  • Learn from the best and forever change your investing perspective
  • One incredible tidbit of knowledge after another in the page-turning masterpiece of a book
  • Discover the secrets to Charlie’s success and how to apply it to your investing
Never Miss A Story!
Subscribe to ValueWalk Newsletter. We respect your privacy.

Congrats! Are you a smart person?

We have an exclusive targeted & limited time offer for being a sophisticated and loyal reader.

ValueWalkPremium is a website and newsletter on the latest industry news much of which is not in the public domain and obtained via our sources.

We also have 10 years of resources on how to use this information to better your investment process.

Sign up for  today and get our exclusive content for 40% off. This is our second biggest discount ever!!

Use coupon code VIP20 or click on the button below

Limited time offer only ENDS 4/30/2020 or after the next 40 subscribers take advantage whichever comes first – please do not share this discount with others

 

0