An Investor's Lesson From Hurricane Sandy

Try this.

Find a news article from before this week discussing the biggest risks that the economy faces later this year. There are hundreds of them. Most focus on three big concerns: Europe, the fiscal cliff, and an earnings slowdown.

But not a single one says anything about what is likely to be the biggest ding to growth over the next three months: Hurricane Sandy.

Sandy could lop 0.6 percentage points off fourth-quarter GDP growth, according to IHS Global Insight. For an economy growing at 2%, that's huge -- likely the most significant single event to hit the economy so far this year.

No economist or analyst saw this risk coming prior to just a few days ago. They couldn't know, because it was unknowable. And that's a great example of what risk really looks like. 

"Risk is what's left over after you think you've thought of everything else," writes financial advisor Carl Richards. The biggest risk usually isn't the stuff making news; It's the stuff that no one is talking about and no one sees coming. 

The best example of this came eleven years ago. Here's a sentence from a news article from September 8, 2001: "[Economists] acknowledged that risks remain, chief among them the continued decline in corporate profits." Think about that. Seventy-two hours before the 9/11 terrorist attacks, the top worry on economists' minds was dwindling corporate profits. Obviously, no economist could have possibly known that a risk magnitudes greater was hours away. But that's the point: Risk is what's left over after you think you've thought of everything else.

When I heard IHS's estimate of Sandy's impact on GDP, I thought about the thousands of economists -- many of them brilliant minds with PhDs -- who spent countless hours forecasting what the economy will do for the rest of the year. Because of Sandy, every model and prediction they made before Monday is void. It's wrong. It's, basically, useless.

That's not a criticism of economists' inability to predict a freak weather storm. It's a criticism of how they -- and so many of us -- view the value of predictions in a world that's so risky and unknowable. In his book, The Black Swan, Nassim Taleb wrote:

The inability to predict outliers implies the inability to predict the course of history ... But we act as though we are able to predict historical events, or, even wore, as if we are able to change the course of history. We produce thirty year projections of social security deficits and oil prices without realizing that we cannot even predict these for next summer -- our cumulative prediction errors for political and economic events are so monstrous that every time I look at the empirical record I have to pinch myself to verify that I am not dreaming. What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it.

What can you do about it? Here's Carl Richards again: "Our assumptions about the future are almost always wrong. We can never think of everything -- but we can take sensible steps to protect ourselves from life's inevitable surprises." For most of us, that means having a lot of liquid savings, and the willingness to adapt to new circumstances. "At its best, life is completely unpredictable," says Christopher Walken. And at worst, you're totally unprepared for it.

Fool contributor Morgan Housel has no positions in the stocks mentioned above. Follow him on Twitter @TMFHousel. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 01, 2012, at 10:30 AM, TMFLomax wrote:

    Great thought-provoking piece, Morgan. I've been thinking a lot about the concept of "black swan events" recently, in light of what's been going on.

    Alyce

  • Report this Comment On November 01, 2012, at 12:27 PM, wolfman225 wrote:

    Wouldn't this lend itself to the argument for traditional "buy & hold"? After all, if we not only can't see these "black swans" coming, and if the prognostications most of us rely on are almost always wrong, I don't see any sense in deviating from the template of choosing strong companies in good industries with strong balance sheets and sound management (or, failing that, simply investing in a broad-based index) and keeping yourself liquid enough to respond to emergencies.

    It would seem to me that most anything else is simply trying to see the future through a cracked crystal ball.

  • Report this Comment On November 01, 2012, at 9:10 PM, decebalvs wrote:

    The brain is a prediction machine at its core, nothing less, nothing more. And it got better and better at it over the millions of years. Today, computer aided modeling can see things which only a few decades ago would have been considered "unpredictable".

    I think am getting a bit tired of this passive attitude. I think the things that truly matter for the society can be predicted and we can make the right decisions before it's too late.

  • Report this Comment On November 02, 2012, at 8:37 AM, Darwood11 wrote:

    Great article, gave me a few moments to reflect.

    Predictions are made in a box with a set of conditions. From that base, they are usually straight line calculations for a day, a month, a year or a decade.

    In a complex, multivariate system, such projections are at best approximations and at worst very crude guesstimates.

    Once we realize that, then we can use these predictions as the grossly flawed things they are. The expression is "all things being equal, then......"

    We as human beings are a problem. Why do we worry about the wrong things? Why do we frequently make poor decisions? There is misinformation; some who make these predictions believe their own Kool-aid. When we hear these predictions there is a tendency to compare to our preconceived notions. If it fits our belief system, then by gosh, it sounds good!

    Even with the best of information inputs, there will always be the unknowable or the unthinkable. There will also be those who provide their beliefs, or information designed to sway opinion.

    My point?

    1. It's critical to choose one's sources with great care.

    2. Don't base one's important decisions solely on the conclusions provided. Study the underlying information.

    3. Develop critical thinking skills.

    4. Take full responsibility for your decisions. They are yours and yours alone.

    5. Expect the unexpected. Nature abhors a vacuum and the only constant is change.

    6. The downside risk is that every plan will fail. As an investor, it's all a crap shoot. But we should not gamble. That's why we use portfolio distribution and allocation. But as we have been recently reminded, sometimes everything goes down in value.

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