HOW GOOD ARE YOU at predicting the future? Well, despite a bazillion bits of information at our fingertips and unbelievable computing power, humans are still pretty bad at it.
Let’s use an example that gets to the heart of the financial crisis. As described in Nate Silver’s book, The Signal and the Noise, back in 2007 Standard & Poor’s Corporation (S&P) gave investment ratings to a particularly complex type of security called collateralized debt obligation (CDO). For CDO’s that were rated AAA – the highest rating possible – S&P said the likelihood that a piece of debt
within those CDO’s would default within five years was a miniscule 0.12 percent. That’s about one chance in 850.
Now, you probably know where this is going. Guess what the actual default rate was? According to S&P, it was around 28 percent. Simple math says the actual default rate was more than 200 times higher than S&P predicted and, as Silver wrote, “This is just about as complete a failure as it is possible to make in a prediction.”
It’s easy to poke fun at bad predictions; however, there is a larger point here. First, we can’t predict the future so we always need a plan B. And, second, we need to differentiate between risk and uncertainty.
Economist Frank Knight said risk involves situations where we can calculate the probability of a particular outcome. For example, actuaries can calculate the probability of a 60-year old male dying within 10 years because they have historical mortality statistics that don’t change much from year to year.
By contrast, uncertainty has no historical data to use as a solid basis for making a prediction. For example, predicting the outcome of war in Syria is not knowable because there’s no set of historical data or probability distribution on which to base the prediction.
It’s just our luck that the financial markets seem to contain elements of risk and uncertainty. However, we can try to use that to our benefit by being cognizant when the risk/reward seems to be in our favor while at the same time, having plan B in case uncertainty tries to spoil the party.
The rest of the report can be found here.
Please be sure to visit the Parks Wealth Management website at www.parkswm.com
James T. Parks, CFP®, AEP, AIF
President and Wealth Advisor