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Expecting the unexpected

There will be many surprises ahead, and many of them will be negative surprises

Expecting the unexpected

Back in February, in what seems like a different world now, I wrote this in a column: If the coronavirus epidemic continues on the path it has done so far, then... here's the real problem - there is no way of completing that sentence which is not a blind guess.

As the months have passed, the blind guess part has receded. By and large, the contours of the crisis are quite clearly visible now and compared to the worst that seemed possible at some point, we are on our way to a substantially better situation. The Chinese virus will claim many more victims but the worst of the disease is clearly over. India's economic recovery has been quite rapid and there appears to be good news on the vaccine front even though I maintain a high degree of scepticism about the conduct of the global pharma industry.

However, therein lies the problem. There is a clear danger now that many of us, as savers and investors, are in the danger of bouncing off too high and too hard from an earlier psychological bottom. For people who are in personal or professional financial problems because of the pandemic, this is not going to happen and there are crores of such people. However, for many of what I'd call the investing class, that's not true. With the markets rising to new highs and the festive season proving to be quite cheery, many investors find their personal wealth to be in surprisingly good shape.

From a psychological point of view, I'm happy for everyone who feels this. However, if there is one thing that the last few months have taught us, it's about the power of the negative surprise. The learning from events like this is not that we must predict better and that everything hinges on the accuracy of those predictions. Instead, the learning is that wildly unpredictable events will hit much more frequently than a naive extrapolation of trends indicates. What's more - and this is the key - such unpredictable events are overwhelmingly more likely to be negative rather than positive.

Does that make sense? Think of it this way. Can there be an event which causes the world's economic output to drop by some catastrophic amount, say 10 per cent, in just a year? Yes, definitely. We're probably looking at such an event even though it may not really be measurable. However, can the opposite happen? Could something happen that could cause an equivalent boost in a year. No, absolutely not. The chances of such a miracle are as close to zero as possible.

Understand that this asymmetry is scale-dependent. Can an individual become wildly rich very quickly? Yes, it happens every day to some people around the world. Can the equivalent happen to a small business? Large business? Entire sector? A country? The whole world? As you go up in scale, the variability reduces. However - the big however - the size and speed of the negative shock possible is always much larger. Apart from trivial examples like winning a lottery, at every scale, the negative surprise can be much more powerful and much more sudden than the positive surprise. This is true not just in finance but in life in general. For example, in our personal health, as so many people have discovered lately.

The moral of the story is very simple, although somewhat hard to implement: expect the unexpected, and expect the unexpected to be worse than the expected. Think of the concept of a financial stress test and check if your investments as well as your financial life (as well as life in general) can manage a bout of severe problems. It's the old cliche of hoping for the best and being prepared for the worst. Like most cliches, it became a cliche because it's true.