plonkee money an english-er's thoughts on personal finance

June 11, 2007

randomness and insurance

Filed under: insurance — plonkee @ 6:20 pm

I’ve recently been thinking about randomness. I like randomness in general, but this has been prompted in particular by my reading of Fooled by Randomness by Nassem Nicholas Taleb. The message (?) that I got from the book was that randomness plays a massive part in the ability of traders to make money. That is to say that most traders do not make money because they are good but because they are lucky. And also that the reason that they get caught out in the end is that they don’t realise that they are lucky.

One of the key things that I took out of it that could actually be applied to personal finance was the role of insurance. In the world of Taleb, the important factor that should be determining whether or not you need insurance (in the general sense) is the expeced value (or cost) of the event.

For those of you that aren’t big fans of probability, this means the probability of the event multiplied by the cost outcome of the event. Taleb argues that most people consider only the frequency of the event and ignore the outcome of the event. This is catastrophic if the cost of the event is literally unbearable. An example of this in general life is the event of your house burning down. This is pretty unlikely, but the cost of it happening is unbearable if you cannot afford to rebuild it. In this case you need to have insurance. In fact, Taleb goes further, for example you need to have insurance not against the specific cause of your house burning down, which is very unlikely, but the more general ‘needing to rebuild your house’.

With insurance, its not about how likely it is, its about how likely it is and how bad the worst possible outcome is. Thats what you need to protect yourself from.

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