Fat Tails and Nonlinearity - Mauboussin

• Avoid the problem of induction. Humans like to generalize about a system based on a limited sample. The problem of induction reminds us that falsification serves us better than verification. When an asset price is going up, the natural assumption is it will continue to do so. Indeed, prosperity can breed an unhealthy sense of security.

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• Be mindful of diversity breakdowns. There is no simple way to measure the degree of diversity in the real world. But if a large group of investors seem to all be doing well pursuing a similar strategy, chances are there is a great deal of invisible vulnerability.

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• Watch for the non-linear reaction. Critical points are endogenous to financial markets, as they are in other complex systems. When diversity levels are low, small perturbations lead to outcomes completely out of proportion with their size.