Rumi, the famous Persian poet, once told a story. A drunk is searching the ground under a street lamp. A friend happens to walk by and asks him what he is doing. The drunk slurs, "I'm looking for my key." The friend helps him search every where. Half an hour later they still have not found the key. The friend asks, "Are you sure you lost it here?" "No," replies the drunk, "I lost it inside my house." "Then why are you looking here?" "Because the light is here."
I read The Plight of the Fortunetellers by Riccardo Rebonato not once but twice. I am not sure I have managed to absorb half of what is offered but this book is changing the way I evaluate risk. The author analyzes why the quants, some of the brightest men in world armed with the largest computers money could buy failed to properly evaluate risk during the real estate crash of 2006 and the subsequent stock market crash of 2008. In short, they were applying statistical methods that while mathematically correct were treating all available data, say 200 years worth, as equally valuable then using that data to predict events that might only happen once in 1,000 years. Such an approach is deeply flawed. First, while we can make such statements about events like flipping a fair coin with a limited data set, the stock market is not as predictable, since it is driven by human greed and fear more than by rational behavior. Secondly, engineers and scientists know that extrapolation beyond points in a known data set is a recipe for disaster. Predicting the future is at best a risky proposition.
It turns out there is a solution. For those who are interested the technical name is Bayesian Probability. Think of it as common sense applied to higher level statistical analysis. The author examines the results of considerable psychological research. Turns out we humans are pretty good at predicting the probability of common events within the most likely 90% of a statistical distribution. It is improbable outcomes out on the tails of these distributions where we run into trouble. We are likely to guess wrong when predicting high cost, low probability events. This results in unprofitable behavior like the purchase of cancer insurance. We are equally bad a predicting the likelihood of highly desirable but unlikely events. This leads us to behaviors like the purchase of lottery tickets.
If you are attempting to solve a problem develop a model based on common sense and the experience of experts in the field. If you were looking for lost car keys, you would intuitively assign a probability to a number of different areas. The first place I would look would be the ignition switch, then on the floor of the car, then on the carport, then the kitchen, moving systematically from the most likely to the least likely spots. Each time I eliminate a location, such as the ignition switch, I unconsciously reassign a new probability to each of the remaining locations. Continue to refine your model until you find the keys.
Do you want to learn more about managing money? Find some old guy who has earned a lot of money over a lifetime. Take him out to lunch and ask him how he did it. Do not ask your broke buddy about his investments. Borrowing money to buy a bass boat is not likely to lead to a high net worth. Read books by recognized experts. This is a little more difficult because there are a lot of kooks out on the Internet promoting themselves as experts. Use this information to develop a model.
I started looking for established companies with a track record of paying a dividend. I then started looking for low Price Earning Ratios. Then I started considering the Price Earnings Growth Ratio. Then I started wondering about how to predict the sustainability of the cash flow necessary to continue paying me my dividend every quarter. Now I am just beginning to consider book value. What does that really mean? Is the real estate used to calculate book value carried at market value or some other fictitious number? Even if the number is good, can the property be conveniently sold some time in the immediate future? What is an abandoned sheet metal factory in Terre Haute, Indiana really worth on today’s market? The learning process never ends. The model is always in flux as old beliefs are discarded and new data is added. This is just me. Your model may look different and work even better.
One more thing, let’s be careful out there.
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A parable featuring the Seljuk Sufi mystic Nasrudin Hodja may be the earliest form of the story: 'Someone saw Nasrudin searching for something on the ground. “What have you lost, Mulla?” he asked. “My key,” said the Mulla. So they both went down on their knees and looked for it. After a time the other man asked: “Where exactly did you drop it?” “In my own house.” “Then why are you looking here?” “There is more light here than inside my own house.”' The Indologist Wendy Doniger quotes this parable in her book The Hindus: An Alternative History, as a way to prepare the reader for the disappointing realization that the “available light” on Hinduism — the hymns, the histories, the archaeological remains — tends to illuminate the perspectives of dominant groups, relegating to the shadows the viewpoints of women, lower castes, and other marginalized groups.
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