The professional trader's paradox

TL;DR

This paper presents a paradox illustrating how misestimating conditional probabilities in finance can distort risk forecasting, emphasizing the importance of understanding non-ergodic effects in financial returns.

Contribution

It introduces a paradox demonstrating the impact of non-independence in financial returns on risk estimation and decision-making.

Findings

Erroneous conditional probability estimation leads to risk distortion.

Different perceptions of dependence affect forecasting accuracy.

Highlighting the importance of non-ergodic considerations in finance.

Abstract

In this article, I will present a paradox whose purpose is to draw your attention to an important topic in finance, concerning the non-independence of the financial returns (non-ergodic hypothesis). In this paradox, we have two people sitting at a table separated by a black sheet so that they cannot see each other and are playing the following game: the person we call A flip a coin and the person we'll call B tries to guess the outcome of the coin flip. At the end of the game, both people are asked to estimate the compound probability of the result obtained. The two people give two different answers, one estimates the events as independent and the other one considers the events as dependent therefore they calculate the conditional probability differently. This paradox show how the erroneous estimation of conditional probability implies a strong distortion of the forecasting skill that can lead us to bear excessive risks.