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August 14, 2007

Voodoo Bell Curve Curses the Fed
by The Mogambo Guru

"...the Fed is doomed to fail, due not by my hating them so much and my putting a voodoo curse on them all, but on its total reliance on the bell curve and probability theory..."

Nassim Nicholas Taleb says that the "central idea" of his book, The Black Swan, is that you can derive a benefit from "the notion of asymmetric outcomes." Suddenly, my ears prick up at attention! A benefit? Great!

He explains it as, "I will never get to know the unknown since, by definition, it is unknown. However, I can always guess how it might affect me, and I should base my decision around that."

In other words, "in order to make a decision you need to focus on the consequences (which you can know) rather than the probability (which you can't know)."

In actual practice, "if my portfolio is exposed to a market crash, the odds of which I can't compute, all I have to do is buy insurance, or get out and invest the amounts I am not willing to ever lose in less risky securities."

In short, one way would be to put the overwhelming majority of your "I must never lose this" assets in the ultra safe category, and use a small bit of your assets going around investing for the Black Swans that will have a huge payoff that is so big that the profit is unbelievably, gloriously disproportionate to the piddly amount invested.

Doug Casey of Casey Research and publisher of the International Speculator newsletter apparently agrees with that, pretty much, and says, "My view is that, certainly in today's world, it's much more prudent to risk 10% of your capital with a prospect of getting a 1,000% return than risk 100% of your capital for the prospect of a 10% (or less) return."

The important theoretical part, to me, is that this whole business of unexpected outliers that have a massively disproportionate impact has made Mr. Taleb reject the use of the ubiquitous Gaussian "bell curve", which he says, "ignores large deviations, cannot handle them, yet makes us confident that we have tamed uncertainty. Its nickname in this book is GIF, Great Intellectual Fraud."

But we are stuck using the bell curve because we have an innate "need to know", even though it is not knowable, which he characterizes as, "the bell curve satisfies the reductionism of the deluded."

Thus, he ridicules predictions and models based upon the upon the bell-curve, including (cue ominous soundtrack) econometric models, as the historical evidence shows that systems based on such a theory have always seemed to be doomed to fail catastrophically because a Black Swan inevitably hits. Which may, and can, and do, produce other Black Swans.

If you noticed that the skies were suddenly filled with thunderclouds and the soundtrack was a cacophony of screams of pain and anguish, gunshots, police sirens and children crying, then you are adequately prepared to assess the situation correctly when I remind you that the monetary policy model that the Federal Reserve uses (mostly to find an excuse to lower interest rates, I say with a sneer) is, is derived from, and is riddled with, the properties of (insert more sounds of demons from hell screaming) this infamous bell curve/probability crap.

In short, I say (and dragging the protesting Mr. Taleb along as my proof) that the Fed is doomed to fail, due not by my hating them so much and my putting a voodoo curse on them all, but on its total reliance on the bell curve and probability theory, and furthermore that you should put the majority of your assets into the ultra-safe investment of gold and silver.

Why gold and silver? Because some bell curves actually do exist, simply because of the long-term absence of Black Swan events, and so things will tend to average around fundamental values, such as the historical values of gold and silver versus currencies, as postulated by "$8,000 Silver in 15 Years" by Jason Hommel of silverstockreport.com, as interviewed by Maurice Rosen.

In it, we glean the interesting observation that in the 1430s, the florin, "a coin containing fifty-four grains of fine gold", had a value such that one could buy a 'handsome palazzo' for a thousand florins, and then staff it with a maidservant for ten florins a year.

With that same gold florin coin, "A man can live very comfortably with an income of 150 florins" in 1430, a "cashier" in the Medici bank makes forty florins a year, an apprentice in the same bank would earn 20 florins a year, and the Medici Palace itself was worth 5,000 florins.

Since one troy ounce in weight equals to 480 grains, Mr. Rosen concludes "while some may have expressed objection at Hommel's projection of gold's remonetized value of $35,000 per ounce, such a price actually has some validity if one uses it as a proxy for comparing the purchasing power of gold between today and the Italian Renaissance."

So it seems that gold and silver are gradually regaining their old glory and value, as I also gather from the newsletter Gold Thoughts by Ned W. Schmidt, where he happily writes "WE WIN!" as he compares "ten year returns on $Gold (7.4% compounded annually) and U.S. paper equities (6.1% total return compounded annually)" to show that "the place to have had your money for past ten years has been Gold."

And in the same vein we have Moneyweek.com noting in the essay "Why the Gold Market is an Investor's Best Friend" that private investors have bought so much of the gold that the central banks sold all these years, that private individuals "now control more of the supply than central banks, according to CPM Group." As Moneyweek says, "That's huge!"

And astonishing, too, because for the first time in modern history, more gold is in private hands than in the vaults of central banks! Amazing!

-- I didn't get a chance to bellow hysterically about how the Conference Board's index of Leading Indicators (representing the future) fell 0.3 percent, which is pretty bad news, or how the index of Coincident Indicators (a gauge of current economic activity), rose a paltry 0.2 percent last month, which is pretty bad news, too, or especially how the index of Lagging Indicators (future inflation) increased a big 0.5 percent, the biggest of all, again, which is terrible news. Consider that omission rectified. Ugh.

Mogambo sez: Besides gold and silver being such a good deal at these prices, oil going down in price, especially by this much, is one of those weird market anomalies that is such a guaranteed good long-term investment that it makes you laugh in gleeful abandon ("Whee!") when you think of all the money that you are going to make simply by buying the stocks of any oil companies that finance it, find it, extract it, collect it, ship it, transport it, refine it, distribute it, or put it at the end of a hose so that you can pump it into your car, enabling you to ride around feeling good, and looking good, with your pockets full of spending cash, a big ol' smile on your face and accompanied by all the happy friends that money can buy.

Sometimes, life IS good!

P.S. To get The Daily Reckoning sent directly to your inbox, sign up for our free email newsletter, or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Richard Daughty, the angriest guy in economics
The Mogambo Guru

Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter - an avocational exercise to heap disrespect on those who desperately deserve it.

The Mogambo Guru is quoted frequently in Barron's, The Daily Reckoning and other fine publications.

Copyright © 2005-2008 Richard Daughty

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