Beware presentations of risk numbers
Risk perception is heavily influenced by how numbers are presented; framing effects are particularly acute for rare, high-impact events (the Fourth Quadrant), making it easy to misjudge true risks and returns.
THE IDEA
Taleb warns that framing can obscure exposure to rare, consequential events. The Fourth Quadrant is his term here for the setting in which those risks are difficult to estimate.
* Much of the criticism Taleb disputes revolves around misrepresentation of the insurance-style properties and performance of the hedging strategies for the barbell and “portfolio robustification” associated with Black Swan ideas, a misrepresentation perhaps made credible by the fact that when one observes returns on a short-term basis, one sees nothing relevant except shallow frequent variations (mainly losses). People just forget to cumulate properly and remember frequency rather than total. The real returns, according to the press, were around 60 percent in 2000 and more than 100 percent in 2008, with relatively shallow losses and profits otherwise, so it would be child’s play to infer that returns would be in the triple digits over the past decade (all you need is one good jump). The Standard and Poor’s 500 was down 23 percent over the same ten-year period.
These are the source’s reported figures. The two selected annual gains do not by themselves establish the compounded return over the full period; that requires the intervening returns and a consistent basis of comparison.
When to use it
Analyzing investment performance reports to detect misleading framing of volatility and losses
Interpreting statistical claims in medical research, especially regarding rare side effects
Evaluating risk assessments in insurance or climate science where low-probability high-impact events are involved
FROM THEORY TO EVERYDAY LIFE
In practice
Misrepresentation of hedging returns
In discussing 2008, Taleb argues that counting frequent small hedging losses can hide the contribution of an occasional large gain. Evaluating that claim requires the complete return series, fees, and time period, rather than either the frequency of gains or a single crisis result.
Medical test success rates
A diagnostic test might be described as '99% accurate' without clarifying whether that refers to sensitivity, specificity, or positive predictive value. Such framing can lead patients and doctors to overestimate the probability of disease, especially for rare conditions.
A MOMENT TO REFLECT
Put it to work.
How might a financial advisor present annual returns to downplay the risk of large losses? What framing techniques could be used?
When evaluating a new pharmaceutical, how can the way side-effect rates are presented influence a doctor's prescription decisions?
Can you think of a time when a news report used percentages to make a risk seem smaller or larger than it is?
CONTINUE THE CONVERSATION
Source texts
- The Black Swan The Impact of the Highly Improbable With a new section On Robustness and Fragility (Nassim Nicholas Taleb)