The Fallacy of Forecasting:
1) Being right on a random variable X does not mean making money off it.
2) Payoff function f(x) needs to be aligned with what you're forecasting.
3) In fact, payoff function f(x) is never X and f(x) can be very complicated.
4) In real life, most people who think you have to focus on X are academics or idiots.
5) Payoff function f(x) is what you focus on when you make a decision.
6) It's much easier to understand the function of your random variable than the random variable itself.
7) You don't have to be right about the world, you have to make decisions that are convex; decisions that make sense.
8) Paranoia is entirely justified if your payoff function f(x) is concave.
9) Overpricing or underpricing probabilities is not what matters, its your payoff function that matters.
@SunTrader doesn't understand this. I blocked him so maybe someone can save his portfolio if you pass the message.
It doesn't matter if you are right or wrong about what you forecast. Getting the forecast right or wrong is actually not the point. You need a payoff function aligned with the forecast. & it's this very payoff function that decisions are(should) be based off of in life.
It's really simple concept, but many forget. Many are focused on win rate and believe if they have a high win rate that this is enough. Too narrow-minded.
Payoff function example:
Disclaimer: Simple statistical concerns are often well clarified through the use of gambling examples.
Example from "The Business of Options" by Martin P. O'Connell, pg. 5
Suppose I would like to bet that I can roll a 4 in a single roll of one die. Of course, if you insist on even odds, I'm not going to bet because I know I only have one chance in six of winning.
On the other hand, if I can get 10-to-1 odds, I am going to make that bet. I am going to make it fully expecting to lose, and I am still going to think about it as a business.
Suppose I make the 10-to-1 bet and roll the die and get a 2 instead of a 4. Was I wrong? Of course not. I'm no dumber than before the roll, and also no dumber than if I had rolled a 4. If I had rolled a 4, the result might make me feel brilliant. That feeling would be simple emotional weakness. To be statistically passive is not just to make a trade without thinking I know the result. It also requires ignoring the temptation to think that the result indicates the quality of the trade.
Learn more here:
https://www.elitetrader.com/et/threads/are-you-too-anxious-to-win.334884/
Edit: Posted this as a new thread so the message can get out to the folks who stopped following this thread. Very important concept.
