On the Statistical Differences between Binary Forecasts and Real World Payoffs
arxiv.org ⎯ last month What do binary (or probabilistic) forecasting abilities have to do with overall performance? We map the difference between (univariate) binary predictions, bets and “beliefs” (expressed as a specific “event” will happen/will not happen) and real-world continuous payoffs (numerical benefits or harm from an event) and show the effect of their conflation and mischaracterization in the decision-science literature. We also examine the differences under thin and fat tails. The effects are: A- Spuriousness of many psychological results particularly those documenting that humans overestimate tail probabilities and rare events, or that they overreact to fears of market crashes, ecological calamities, etc. Many perceived “biases” are just mischaracterizations by psychologists. There is also a misuse of Hayekian arguments in promoting prediction markets. We quantify such conflations with a metric for “pseudo-overestimation”. B- Being a “good forecaster” in binary space doesn’t lead to having a good actual performance}, and vice versa, especially under nonlinearities. A binary forecasting record is likely to be a reverse indicator under some classes of distributions. Deeper uncertainty or more complicated and realistic probability distribution worsen the conflation . C- Machine Learning: Some nonlinear payoff functions, while not lending themselves to verbalistic expressions and “forecasts”, are well captured by ML or expressed in option contracts. D- Fattailedness: The difference is exacerbated in the power law classes of probability distributions.
