Dr Paul Kaplan kicked off with his view on ‘black swans’, or market events of unpredictable and never-seen-before nature: There hasn’t actually been any, Kaplan says. Instead, what he observes are events known as ‘black turkeys’ – a repetition of previously-observed events, which still manage to surprise everyone.
Dr Sam Savage takes to the stage and starts by talking of the “flaw of averages”, which he says appears everywhere in life. Savage highlights the story of a statistician who drowned crossing a river that was 3 feet deep on average. How could he drown in such a shallow river? Because the average depth may have been 3 feet but that belies a substantial drop mid-river.
Following on from this ‘flaw of averages’, Savage says another way to calculate risk and forecast outcomes, a method that does not use means or co-variances, is to rely on scenarios. Using an approach as simple as rolling a dice 1,000 times and recording the results is the foundation of the science of probability management, he says. This differs from the law of averages because it asks for the generation of thousands of scenarios, the storage of river depth data of hundreds of rivers if you will, before yielding a result of how deep the river is. The need to compress that data in a more manageable way is the birth of the distribution string concept (DIST) founded by Savage.
Kaplan gives a demonstration of new data and risk measurement tools contained in Morningstar Direct.
“I don’t like words like ‘correlation’ or ‘co-variance’ – these aren’t words you can utter in a singles’ bar, for example. I prefer words like ‘dependence’,” Savage says.
The above is an excerpt of Drs Kaplan and Savage's discussion. A video covering the key themes of their presentation will be available on Morningstar.co.uk shortly.
