From the income distribution of Vilfredo Pareto (1896), carried into markets by Benoit Mandelbrot (1963), surveyed by M. E. J. Newman (2005), and brought to risk by Nassim Nicholas Taleb (2007).
Assumes a few extreme cases dominate the total until the data shows otherwise, so averages, ranges, and risk limits are not built on a bell curve that does not fit.
When to reach for it
Sizing rare-event risk, reading data with a few huge outliers, or designing anything that must survive the worst case.
How it runs
- Plot the data on log-log axes before computing averages.
- If the tail is fatter than exponential, distrust the mean and variance.
- Fit the tail with rank-frequency or maximum-likelihood methods.
- Size plans and limits for the tail outcome.
Where it sits in SOLVE eX
Go to the source
- Cours d'economie politique, F. Rouge, Lausanne, 1896
- The Variation of Certain Speculative Prices, Journal of Business 36(4), 1963
- Power Laws, Pareto Distributions and Zipf's Law, Contemporary Physics 46(5), 2005
- The Black Swan: The Impact of the Highly Improbable, Random House, 2007