A few moments ago, CNBC broadcast a weather report showing the best and worst case scenarios for the potential left and right track of Hurricane Earl. They projected it will “brush the East Coast on Thursday”. Weather channels, however, are saying “Friday” is the H-day. Who’s right?
There is literally no way to know – until it happens. And they have better data and models than any trader or quant on the planet. With markets, a flash crash or its cousin – the hedge fund implosion – can literally occur at any moment. A hurricane, on the other hand, will never take a sudden turn to the left or right…. never!
Why does this matter to market players? It matters because the human brain implicitly knows the difference between solving an algebra problem for X, predicting a hurricane and markets. In the latter two are successively higher levels of uncertainty and the brain is going to use context to make judgment calls about how to react. Furthermore, a big part of that context is going to be in the realm of subjective level of beliefs regarding possible outcomes – some in NYC may say we haven’t seen a hurricane in years and some are going to be ordering from Fresh Direct for Wednesday delivery (me!). Why the difference? Beliefs basically … most will assume the recent past tells the future (the recency bias in behavioral finance). I on the other hand, as a consultant in better risk thinking, am trained to think about the risks others don’t notice. Having a very full fridge is a mild price to pay if the winds and rains become a real deterrent to going outside.
The point is that all market and trading models and plans need to explicitly leave room for judgment – judgment that also externalizes beliefs and confidence levels. Every model is uncertain – whether it be for Uncle Earl or for implied volatility. Getting comfortable with that up-front and NOT when you have to make a decision will serve your portfolio, your trades and your fridge quite well.
30 hours later … and only two days from NYC and the forecast is LESS certain not more. Meteorological models now are showing a front moving in from Chicago that /could/ pull the storm westward and onto the NE coastline of the US.
Quiz – do we know more or less about Earl than we know about the markets? The Dow was up 250 or so points today…. what does that mean (besides bonds took the downward slope).