Wednesday, April 13, 2011

Suppressing risk only increases tail risk and chances of blowups

All natural things are Gaussian in nature.

Take wealth distribution for example. The moment a person becomes increasingly wealthy, then his chances of being robbed or blackmailed increases. In more traditional countries, people go out of their way to act poor so that the risk of getting robbed or blackmailed is reduced. This keeps the distribution more or less Gaussian.

But the problem becomes nonlinear once someone introduces laws that protect property and ensure safety. The moment such laws are introduced to protect a person's wealth then his wealth grows nonlinearly and exponentially. The end result is that if you sample 100 people, then 90% of the wealth would be distributed among 1-5 persons while the rest would be classified as poor. Without law and regulation, the 95 poor souls would try and rob these 5 rich people. So laws and regulations make the rich more infrequent but their impact is greater.

The clip above is a must watch. The clip is about traffic in the absence of any regulation. The traffic apparently flows very smoothly with little or no hindrances. Now some people would criticize the absence of law on the roads in Iran. But the traffic accidents are Gaussian in such a situation. People will drive slowly and carefully and there will be more accidents but of less severity. Now, suppose this is a developed country with first world road rules. Then, their would be lesser traffic accidents but the drivers would drive faster and less carefully and when a traffic accident happens then it would be more severe.

So, is law making distributions prone to tail risk.

PS: I have driven in the roads shown in the video and trust me, I feel a lot safer, drive a lot slowly and carefully compared to driving on a motorway in a developed world.

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