Errors, Robustness, and the Fourth Quadrant

Abstract:     
The paper presents evidence that econometric techniques based on variance- L2 norm are flawed -and do not replicate. The result is un-computability of role of tail events. The paper proposes a methodology to calibrate decisions to the degree (and computability) of forecast error. It classifies decision payoffs in two types: simple payoffs (true/false or binary) and complex (higher moments); and randomness into type-1 (thin tails) and type-2 (true fat tails) and shows the errors for the estimation of small probability payoffs for type 2 randomness. The Fourth Quadrant is where payoffs are complex with type-2 randomness. We propose solutions to mitigate the effect of the Fourth Quadrant based on the nature of complex systems.

Keywords: complexity, decision theory, fat tails, risk management

JEL Classifications: D8, G11, G12, G13, N00

Working Paper Series