International Law

How Not to Guess About the Uncertain Future

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Charlie Munger often talks about solving predictions about real life by the technique of inversion.

"The way complex adaptive systems work and the way mental constructs work is that problems frequently get easier, I'd even say usually are easier to solve if you turn them around in reverse.

In other words, if you want to help India, the question you should ask is not "how can I help India", it's "what is doing the worst damage in India? What will automatically do the worst damage and how do I avoid it?"

In life, unless you're more gifted than Einstein, inversion will help you solve problems.

Let me use a little inversion now. What will really fail in life? What do you want to avoid? Such an easy answer: sloth and unreliability. If you're unreliable it doesn't matter what your virtues are.

Doing what you have faithfully engaged to do should be an automatic part of your conduct. You want to avoid sloth and unreliability."

Here is another simple example making predictions, when there is nothing in the past data which would lead you to the right conclusion.

"Taking housing as an example, it's likely that AIG underestimated the probability of super-senior tranches suffering losses since for this to happen you would need a nationwide fall in housing prices (something we havent seen too often) as actual mortgage bonds making up the CDO tend to be well diversified by region.

If you look at the data, you would think the likelihood of this happening is nil, however, this is exactly what happened.

Although AIG avoided the worst vintage years, it clearly underestimated the risk that a banking crisis followed by a recession would have a nationwide impact on housing prices.

Continuing the logic, if one super-senior tranche gets hit, indicating we are in a nationwide slump in housing prices, that means other super-senior tranches are very likely to be hit as well.

Selling protection on ABS CDOs on a diversified nationwide portfolio of mortgages is quite different from holding a well diversified portfolio of fire insurance policies.

The former is much less diversifed than the latter."

If you start from the proposition that the super-senior tranche got hit, no matter what you think that the past data indicates, then the features of our decision making brain, availability heuretic, anchoring, and vividness heurestic, will all kick in to make out a plausible story of how it came to be that the super-senior tranche got hit.

If you want to avoid a disaster, assume that the disaster has taken place and let reason explain to you how it must have happened.

This is not a mere theoretical point.  Having interviewed more than five or six hundred people who lost their saving in either a franchise or business opportunity distribution scheme, I am amazed by the number of people who knew exactly the steps that they should have taken to avoid the fraud, once the fraud was uncovered.

Full post as published by Misleading Advertising Law on March 10, 2009 (boomark / email).