Monday, September 21, 2015

Looking at extremes - the basis for good scenario analysis






Much of the real world is controlled as much by the “tails” of distributions as by means or averages: by the exceptional, not the mean; by the catastrophe, not the steady drip; by the very rich, not the “middle class.” We need to free ourselves from “average” thinking.
Philip W. Anderson, Nobel Prize Recipient, Physics 


There is nothing wrong with focusing on the average or expected value, the most likely scenario. Every event cannot be exceptional, but we have to accept that the exceptional in all parts of life may make all the difference in the world. History is driven by exceptional movements. It is not the march of history but the sprint at key times which have decided the fate of big events. Exceptional events by their very nature are surprises and are not expected. The average is no surprise. The extremes are what cause changes in behavior, changes in outlook, and creates the demand for innovation. 

Hence, the focus of much investment analysis has to be on what could be unexpected, or what could be at the extremes. The pull of the extremes actually changes the mean, so even if an extreme event does not occur it will still affect expected values.  Scenarios should not try and focus on story-telling of what is likely to happen but on what will be the result if a surprise happens. 

Take the case of the Fed. Currently the likely result is action by the end of the year. The surprise scenario will be not just a delay but another round of QE. Focusing on what would cause that scenario may be more important than joining the consensus. If if this extreme does not occur, the right analysis is handicapping the possibility of this type of an event. 

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