mental-models-risk-uncertainty

5 Mental Models For Uncertainty, Randomness & Risk

These are 5 Mental Models for risk, uncertainty, randomness and luck.

There is so much complexity to probability and randomness that trying to understand it all is a fools game. We can however, apply some key mental models for risk and uncertainty to try better understand these complex issues.

The Black Swan

The Black Swan refers to unpredictable and extreme events. They are by definition unforeseen and typically reap a disproportionately large downside.

It is the responsibility of every individual to do their best at pricing in the Black Swan into their lives. Making themselves more robust to risk.

  • The 2008 GFC was a Black Swan event.
  • 9/11 was a Black Swan event.
  • The 2004 Indonesian Tsunami was a Black Swan event.
  • Leicester City winning the 2006 Premier League is a Black Swan event.

Black Swan events are extremely high risk, low probability (fat tailed) events.

Listen To My Podcast On The Black Swan By Nassim Taleb – HERE

Fat Tailed Distributions

Source

Fat-Tailed distributions are high risk. Notice that you can experience up to four standard deviations in the green or the red on the above (red line) distribution.

The point of highlighting Fat-Tailed distribution is in acknowledging that although the chances are low, Fat-Tailed distributions expose you to knock out losses.

Much of the social world is said to be fat tailed, rather than is misleadingly assumed, normally distributed.

Your marriage is fat tailed.

At +/- four standard deviations from the mean. You are exposed to the slight chance of life ruining divorce, at -4.00SD, which is a knock out blow. But equally, you are exposed to life long fulfilment, +4.00SD. There is a symmetry between the upside and the downside.

Both outcomes that are not achievable at two standard deviations on a normal distribution.

Listen To An Explanation Of Fat-Tailed Events In My Podcast On Extremistan V. Mediocristan

Simpson’s Paradox

Always test your correlation with a strong dose of salt.

You can infer much from highly correlated data. Many policies and decisions are justified because of this. But once that highly correlated data is combined your inference can be flipped completely on its head.

Trends that appear when a dataset is separated into groups – reverse –when the data are aggregated.

The Lindy Effect

The Lindy effect emphasises the saying, ‘… an oldy, but a goody!’

The older something is, the more likely that makes it to be around in the future.

Star Wars IV was released in 1977 and as of today, 43 years on, is still an all-timer. The Lindy effect tells us this means we can predict with confidence that Star Wars IV will at least maintain popularity and relevance for another 43 years. The Lindy effect measures robustness.

If an idea has survived 3,000 years – Stoicism – then we can infer from the Lindy effect, that Stoicism will survive at least another 3,000.

Listen To My Podcast Explaining The Lindy Effect

Randomness

We struggle to accept it’s dominant existence, and refuse to attribute it our success.

The world is largely comprised by random, non-sequential, non-ordered events.

As Nassim Taleb coined…

We are ‘Fooled By Randomness’ all the time. When we attribute causality to things that are actually outside of our control we will tend to see things as more predictable and therefore allow ourselves a chance to act in accordance.

Check Out My Article On ‘Fooled By Randomness‘ By Nassim Taleb & Also Check Out My Podcast On Randomness.

These are 5 Mental Models for risk. Nassim Taleb is the guru of risk. I write about him a lot and also have mad The Incerto & Nassim Taleb Podcast to further the exploration.

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