Forecasting, Causality, the Black Swan, and Your Edge
There are 72,084 move combinations after each player has made two moves and over 288 billion scenarios after four moves each. The Shannon Number, which represents a conservative lower bound of the game-tree complexity of chess (the total possible move variations), is thought to be between 10^111 and 10^123. By comparison, there are 10^81 atoms that make up the known universe. I think we can all agree that national and global markets and economies are far more complex than chess. So tell me again why you think you can predict what will happen next in the markets or in the economy….”
—Bob Seawright, The Prediction Game
Maybe we should stop looking for causality as a source of confidence for our forecasts; especially if our causality flows from deductive reasoning.
Why we cling to beliefs
Karl Popper, a German philosopher, referred to the black swan in his 1953 essay on The Problem with Induction. Induction application in the financial world is best known as “back testing.” Reading Popper gives one a deeper understanding of why we cling to beliefs so tightly and assume we can confidently project our expectations into the future and be confident we will be right.
Popper was fond of the philosopher David Hume and used his reasoning for much of the basis of his argument about induction, carrying it further. Popper wrote [my emphasis]:
But Hume held, at the same time, that although induction was rationally invalid, it was a psychological fact, and that we all rely on it. [We do rely upon it in our everyday life and it serves us well in lots of areas. But because “every moment in the market is unique” it serves us less well there.]
Thus, Hume’s two problems of induction were:
The logical problem: Are we rationally justified in reasoning from repeated instances of which we have had experience to instances of which we have had no experience?
Hume’s unrelenting answer was: No, we are not justified, however great the number of repetitions may be. [The point here again each moment in the market is unique; it’s may rhyme with the past, but there are differences.]
And Hume added it did not make the slightest difference if, in this problem, we ask for the justification not of certain belief, but of probable belief.
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