Econometrics: The Big Disappointment

A mathematician, an accountant and an economist apply for the same job.  The interviewer calls in the mathematician and asks "What do two plus two equal?" The mathematician replies "Four." The interviewer asks "Four, exactly?" The mathematician looks at the interviewer incredulously and says "Yes, four, exactly."  Then the interviewer calls in the accountant and asks the same question "What do two plus two equal?" The accountant says "On average, four - give or take ten percent, but on average, four."  Then the interviewer calls in the economist and poses the same question "What do two plus two equal?" The economist gets up, locks the door, closes the shade, sits down next to the interviewer and says "What do you want it to equal?" 

Three econometricians went out hunting, and came across a large deer. The first econometrician fired, but missed, by a meter to the left. The second econometrician fired, but also missed, by a meter to the right. The third econometrician didn't fire, but shouted in triumph, "We got it! We got it!" 

A mathematician, a theoretical economist and an econometrician are asked to find a black cat (who doesn't really exist) in a closed room with the lights off:   The mathematician gets crazy trying to find a black cat that doesn't exist inside the darkened room and ends up in a psychiatric hospital.  The theoretical economist is unable to catch the black cat that doesn't exist inside the darkened room, but exits the room proudly proclaiming that he can construct a model to describe all his movements with extreme accuracy.   The econometrician walks securely into the darkened room, spend one hour looking for the black cat that doesn't exist and shouts from inside the room that he has it caught by the neck." 

 

It is easy to pick on Economists as the jokes above show.  Economics, in my mind, has always been an art even though it falls under the sciences at universities.  In an effort to try to make it more precise Econometrics was devised whereby economists use mathematical modeling to determine the probability of certain outcomes.  I remember when I was studying economics back in the early 80's this was thought to be the future of the industry that would unlock the secrets of the investment universe so that investors would be able to determine with clarity the risk of an investment and the likelihood of an unwanted economic event.

Fast forward 30 years and while the models have become more and more sophisticated so has the investment marketplace.  As more and more intricate investment derivatives are created the ability of the econometric model to predict the risk of an event and more specifically the chance of a fat tail event are becoming more and more feeble.  A fat tail event is an event that is not captured under the normal bell curve and therefore has fantastic or disastrous consequences on your portfolio.  The fatter the tail the more likely an unknown event is to occur.  Finding these fat tails is the job of econometrics but the models have for all intents and purposes failed.

So let's take a look at the two sides of a fat tail.  On the one side you have the unknown event that helps you tremendously.  For example a cousin's, aunt's mother tells you to dump $100K into Facebook while Zuckerberg is still in college.  Little do you know it at the time but it is about to turn you into a billionaire.  On the other side of the tail is the catastrophe that was 9/11.  On that morning no one was to know what was about to happen and this played havoc with your investment returns, not to mention the poor people and families that were directly involved in the tragedy.  This is a fat tail event that was unpredictable and has disastrous consequences. 

So although mathematical models are used by economists to take a shot at predicting the future they are not able to capture the one event that haunts ever money manager.  In order to protect your portfolio from these fat tail events it has to be broadly diversified.  By this I do not mean just into a basket of stocks and bonds but into assets beyond those.  In my recently published book How To Thrive In The Obama Economy" (available now on Amazon see link below) I explain the reasons why it is more critical than ever today to look beyond a "normal" portfolio.  I encourage you to read the book as I am certain it will help your investment philosophy and your returns.

Looking further at fat tail events there is no need to look further than the returns on the stock market.  Since its inception there have been on average 12,000 listed companies.  Of these companies roughly 300 represent half of the total stock market capitalization.  Furthermore a lot of companies go bust year after year and are replaced by new companies.  What this means is that over time only a small fraction of companies have made investors any real money.  Miss these companies and your portfolio will really be hurt.  This is why investors buy the market using ETFs and is a reason why they are so popular however this strategy opens up the portfolio to the fat tail event.  The need to protect your portfolio outside of this one allocation is more important today than ever so take heed, open your eyes and prosper.

http://www.amazon.com/Thrive-Obama-Economy-Stephen-Bick/dp/1490975128/ref=sr_1_1?s=books&ie=UTF8&qid=1379694723&sr=1-1&keywords=stephen+bick