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Exclusive Interview: How to Prosper in an Uncertain World

In 1998, analysts predicted that the price of oil would stay around $10 a barrel for the following decade. They were off by a factor of 14.

Ten years ago, the Congressional Budget Office predicted that the national debt would be paid off by 2009. It was off by $12 trillion.

In 2007, analysts predicted that S&P 500 (SNPINDEX: ^GSPC  )  earnings would come in at $94 in 2008. They were off by 50%.

These types of stories are all around us. They are the norm. And the big lesson from them is that the unthinkable happens all the time.

How do you, an investor, prosper in a world shocked by surprises year after year? Last week I sat down with Mohamed El-Erian, CEO of bond giant PIMCO, and asked him just that. He told a great story about how he and PIMCO navigated the Lehman Brothers crisis four years ago. Have a look (transcript follows):

Mohamed El-Erian: So, going into 2008, our slogan was, "The unthinkable is thinkable." And we had a list of "unthinkables," and that list fell short of what actually happened. So the first thing that ... I learned is think outside the box, but don't limit yourself when you think outside the box. Because, really, when you have such an interconnected system, you can have unthinkables that are three, four times as unthinkable as you once thought.

So the first issue is always, always consider different scenario analysis. Don't think that there's only one alternative. The second is make sure you have action plans. Because what differentiates you and how you serve your client is not just getting the probabilities right, but also making sure that you can navigate when you get the probabilities wrong.

So let me tell you the Lehman story. The conventional wisdom is PIMCO navigated Lehman really well, and we did for our clients. And the clients have rewarded us accordingly with entrusting us with more assets. Then the next conventional wisdom is they predicted Lehman. So the reality is yes, we navigated Lehman really well, but we did not predict Lehman. Let me tell you what we actually did. The weekend of Lehman Brothers, we were in a room on the other side there, our investment committee. We had three scenarios on the board. Scenario A was that Lehman would be a repeat of Bear Stern, that in the final, final moment, a minute before midnight, a bigger bank would come over, would take over Lehman, the system would open on Monday, and it would be stable because a stronger balance sheet was found to incorporate Lehman. That's what happened when JPMorgan Chase (NYSE: JPM  ) took over Bear Sterns. We gave that the highest probability.

The second scenario was that Lehman would default, but default in an orderly fashion. We gave that the second-highest probability. The third scenario was that Lehman would default, but default in a disorderly fashion. We gave that the lowest probability, because we said no one in their right mind would allow this to happen. Come at about 8 p.m. California time that Sunday, it was obvious that we had gotten the probabilities wrong. That Lehman was going to default, and it was going to default in a disorderly fashion. But we had an action plan for each of these scenarios, very detailed, including at what time would the lawyer take the notice of failure to Lehman in order to allow us to reconstitute positions elsewhere and protect our clients so that our clients are fully protected.

So we had an action plan for every single scenario. Because of that, we were able to launch the action plan immediately when we got the facts. We got a two-day advance on most of our competitors, which allowed us to reposition our clients really quickly. That is the secret.

So the other thing I took away is it's not enough to think of different scenarios, but there's tremendous value in having detailed action plans to protect your clients. So this year, for example, in New York, we have one of the most detailed European crisis responses. Incredibly detailed, including in my wallet, I have a list of names as who's responsible for everything that could be affected on that. And I tell people it's better to plan for a problem that doesn't happen than not plan for a problem that does happen.


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