Low likelihood, high impact events

With an exciting title like that, you must be just glued to the screen right now! Probably not, but stay with me and you may see why I think this is important stuff.

One of the hardest concepts to grasp is how low likelihood, high impact events can really effect our lives. What do I mean by that? Think of winning the lottery. Now, I have your attention. That's a low likelihood, high impact event. So is inheriting a million dollars from a distant aunt you've never met. But, so is getting struck by lightning or attacked by a shark. In other words, such events can be both good and bad, and their impacts are so great as to be really important to us.

The field of investing is filled with such events. According to finance theory, the likelihood of the 1987 stock market crash was statistically impossible, and yet it happened. That is an illustration of a low likelihood event, and an example of how low likelihood events occur much more frequently than theory predicts (fat tails for you statistical types out there).

The problem is that while most people eagerly seek out low likelihood, good impact events (playing the lottery), they also dismiss low likelihood, bad impact events. They think, "that's so unlikely to happen, I'm just going to assume it never happens to me." Not the right way to think about things, buster.

Consider speeding up to make a yellow light. Suppose you make it through the light the first 999 times, but crash into someone and kill them on the 1,000th time. If you knew those were the chances you were taking, would you speed up to try to make the light? I sure wouldn't.

One of the difficulties, here, is that it's hard to know the probabilities. Will you t-bone someone else's car 1 out of a thousand times, 1 out of a million times, or 1 out of a billion times? If you thought about it, you may decide never to take that chance because you don't ever want to court such a disaster. The problem is that most people just decide not to think about it, and have no idea what risks they're taking.

The same problem occurs with investing. Because most people don't know the odds--and prefer never to think about it--they take chances that eventually lead to very negative outcomes. If you go to Vegas and gamble often enough, you will lose.

Think about a bank. The way a bank works is it borrows $900 from other people, puts it's own $100 into the pot, and then makes loans of around $1,000. If 10% of those loans go south, then the bankers get wiped out. Would you want to be a banker and assume that 10% of your loans would never, ever go into default? What if I told you that credit cycles happen every 70 years and that bankers get wiped out when that happens? Makes you want to know the odds, doesn't it?

And that's the point with investing, too. It's very important to know the odds of something bad happening, and what the impact will be if that bad event occurs. If you don't know the odds, or if you can't handle a bad event no matter what, you probably don't want to play.

Everyone has to assume some risks, but there are many risks people take even when they don't need to. Learning to avoid bad risks and take good risks is the art and science of investing. Surprisingly to most, it turns out avoiding bad risks is what most investment success is about.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.