Power Law

Power laws are very interesting for entrepreneurs. I never learned about them when I was taking statistics. I learned good old standard, Gaussian statistics, means, modes, medians, standard deviation, variance, etc. These are still valuable but they don't help describe many data distributions.

From Wikipedia, the free, on-line encyclopedia, we find:

A power law is a mathematical formula which states that as a phenomenon increases in scale, it also decreases in frequency. For example, when the size of an earthquake doubles, it becomes four times as rare. When the size of a stock market fluctuation doubles, it becomes 16 times as rare. The exact fraction does not matter; it is the general law that counts. What this law indicates is that there is no such thing as an average size for an earthquake or a stock-market fluctuation. There is no median point around which they all cluster

Go read the entire Wikipedia article and follow its links and references. There's a bunch of stuff I'm reading about it right now.

The entrepreneur needs to know about power laws because they describe a whole bunch of things about the world that Gaussian statistics doesn't touch. For example, how likely is it that the market will exhibit another big crash soon? The answer is not very likely at all because we already had a Big One. Analyses of stock market crashes shows that when you have a big one, another big one is not likely for some time. A lot of little declines precludes a big dip in the near term. Big crashes are rare, but when they happen, their consequences are severe.

And those who've looked into it say that the same things that produce little crashes, produce big ones. So we need to not worry about little crashes, just work to protect ourselves against the consequences of big ones.

What do you think about this? Post a comment.

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