Tuesday, November 28, 2006

Geniuses appear to be morons

Early in the life of this blog, I posted about core drivers (even needs), an insider's view, about those of us who enjoy trading futures on TS. A snippet:

An even higher aspiration than wrestling with one's fellow man, there is something in each one of us that wants to be able to predict the future. To see farther, to understand more, to know Truth. If we can make the call to go left vs right, to take the shortcut, to go for it on fourth down, to see the incoming missile and get to cover in time, we can save ourselves and our loved ones. We'd be qualified to lead others to safety, and even to the Promised Land.
Now, two of my favorite bloggers, Scott Adams and Alex Tabbarok, have taken up the subject of being radically correct, even while being accused as being wrong. The cartoonist says:
And you probably know from your own experience that if you have an incredible idea of your own – the sort that is later proven to be genius because it works – that people around you will consider you a moron right up until the point your idea works. Then they’ll think you’re a lucky moron. Genius looks just like stupidity to the observer.
The professor says, about Milton Friedman (my favorite economist):
Friedman sets up a very simple model, Z(t)=X(t)+Y(t) where Z(t) is income at time t, X(t) is what income would be if there were no counter-cyclical government policy and Y(t) is the amount added to or subtracted from X(t) by the history of government policy.

You wouldn't think that much could come out of such a simple model but Friedman takes the model, notes that the formula for the variance of two random variables is V(Z)=V(X)+V(Y)+2 r(X,Y) Sd(X) Sd(Y) (where V is variance, r correlation and Sd is standard deviation) and proceeds to show that:

In order to cut the variance of income fluctuations in half (which would cut the standard deviation by less than a third), r(x,y) must exceed .7.

But was Friedman right? In the thirty or so years after he wrote, when counter-cyclical policy was in vogue, the variance of the US economy was much lower than in the pre-World War I years. Reality it appeared, refuted Milton Friedman.

Friedman, however, lived to see his simple model proved correct (Essays in Positive Economics!). In a series of papers beginning in 1986, Christina Romer showed that the pre-WWI volatility was an artifact of the way the data was collected. Once the pre-WWI and post-WWII data were collected consistently, using the same methods, the post-WWII economy showed no big drop in volatility.

Almost nothing in, a surprising and powerful result out, and an implicit prediction proven correct after thirty years. That's the Friedman magic.

A Teacher long ago also once said as much, in stating "a prophet has no honor in his hometown".

So for those of you who are being accused as morons: if your trading P/L is consistently positive, don't listen to the peanut gallery. But if you are not profitable, maybe the gallery is right.

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