The Power of the Infrequent Event

As I've stated before, I am wary of economic and financial forecasters. Mainly because they are seldom right, and when they are wrong the social impact is significant. There exists a fallacy in economic and financial forecasting models that most tend to ignore. The fallacy exists because forecasting models rely on assumptions that fall within a predictable realm. The calculation of risk in financial and economic models are based on standard deviations from the norm, therefore most models predict that 95% of possible outcomes will fall within 3 standard deviations. The farther an event falls from the norm, the less statistical significance that event carries. Another term for standard deviation is sigma. In finance, a six sigma event is characterized by a price drop of six times the volatility (or standard deviations) of the asset. On a daily horizon this translates into an event occurring once every 2,500,000 million days, or every 6,849 years. Yet in the past 22 years financial markets have suffered the following six sigma events: the '87 market crash, the Russian devaluation, the Asian crisis, the bursting of the Internet bubble, and the current 2009 recession.

Since my first day in Econ 101, I've been struck by the absurdity of academic rigor. On that day my professor managed to take an intuitive concept and confuse it. Of course if more people demand my product I can charge more, and guess what? If I'm the only one making my product and a lot of people want it, I can charge whatever I want for that product! That led to discussions of elasticity and more classes to include economic modeling. Even then, I was wary, how could any econometric model take every possible variable and interaction into account? The answer is they can't. That's why we've had multiple six sigma events (events that statistically should occur only once every 6,849 years) in the past 22 years. The problem with these models is that they can't predict that terrorists will fly planes into the world trade center, or an outbreak of the flu may cripple consumer spending in the domestic US market, or that some inventor will develop a battery that can safely store energy with 99% efficiency. Heck, they can't even predict events they should, like the over valuation of US residential real estate market, or that someone that makes $40,000.00 per year can't repay a $400,000.00 mortgage.

The point here is that infrequent events shape our history and our future. Its not the predictable that we should concern ourselves with; Its the unpredictable. In investing, the return on placing a winning bet on the infrequent event is far greater than placing a winning bet on the predictable event, especially when placing that bet on the predictable event is negatively impacted by an infrequent event. To do this you must expose yourself the infrequent events and place your bets. Look for that inventor that is developing the battery that stores energy with 99% efficiency. Look for that company that is converting 18 wheelers from diesel to natural gas. Look for the next breakout technology, tablet computing across 4G? What's the next break-out application? Where does social media take us? There are opportunities to bet on infrequent events, whether you bet on business, politics, or social issues. You just need some creativity.