Executive Briefings

Because Some Events Are Rare Doesn't Mean We Should Not Forecast Them

Many firms think that since rare events are unpredictable, then there is no sense in doing much about them other than "risk transfer" (purchasing a risk product, if one is available, such as product liability, property and casualty and so on).

Nassim Nicholas Taleb, author Black Swan, speaks about the high impact of rare events:

"We don't understand the world as well as we think we do and tend to be fooled by false patterns, mistake luck for skills (the fooled by randomness effect), overestimate knowledge about rare events (Black Swans), as well as human understanding, something that has been getting worse with the increase in complexity."

A few pointers here. If we think back to 9-11, everyone came to the conclusion that we were impacted mostly due to a failure to imagine. We were sitting on the information. This was the same in the recent Japanese earthquake. Or, in the case of Katrina. Taleb's premise is that the modelers and forecasters look through a faulty lens; they discount these events because they are rare:

"We learn from crisis to crisis that modern financial theory has the empirical and scientific validity of astrology (without the aesthetics); yet the lessons are forgotten and ignored in what is taught to 150,000 business school students worldwide."

His position, I think, is this: these events are forecastable, so we ought to include, not exclude them in our forecasts. There is too much at stake not to.

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Many firms think that since rare events are unpredictable, then there is no sense in doing much about them other than "risk transfer" (purchasing a risk product, if one is available, such as product liability, property and casualty and so on).

Nassim Nicholas Taleb, author Black Swan, speaks about the high impact of rare events:

"We don't understand the world as well as we think we do and tend to be fooled by false patterns, mistake luck for skills (the fooled by randomness effect), overestimate knowledge about rare events (Black Swans), as well as human understanding, something that has been getting worse with the increase in complexity."

A few pointers here. If we think back to 9-11, everyone came to the conclusion that we were impacted mostly due to a failure to imagine. We were sitting on the information. This was the same in the recent Japanese earthquake. Or, in the case of Katrina. Taleb's premise is that the modelers and forecasters look through a faulty lens; they discount these events because they are rare:

"We learn from crisis to crisis that modern financial theory has the empirical and scientific validity of astrology (without the aesthetics); yet the lessons are forgotten and ignored in what is taught to 150,000 business school students worldwide."

His position, I think, is this: these events are forecastable, so we ought to include, not exclude them in our forecasts. There is too much at stake not to.

Read Full Article