Predictions and Black Swans

What is a prediction?  How does one evaluate whether the prediction was accurate?  What is "edge" and how does it differ from a specific forecast?

These are questions that every market participant should understand.  Few actually do.

Extremely Unlikely Events

Eddy Elfenbein at Crossing Wall Street  is one of my colleagues at’s RealMoney site.   Eddy provides  interesting perspectives on the market and  many research posts highlighting observations not noted elsewhere.  Eddy (now added to our list of featured sites) has been on our "daily read" list for a long time.  This week he raises an interesting question about predictions and the market, using one of our favorite comparisons — sports.  While we maintain that investing is not gambling, there are many reasons to use the analysis of gambling to study risk/reward in investing.  Most significantly, there are more predictive opportunities, so the study of results is more robust.

Eddy considers one of this week’s NFL matchups, the hapless Dolphins playing the apparently invincible Patriots.  He notes the similarities between investment markets and the free market in wagering on NFL games, observing that there are not many similar cases.

This is a good "Black Swan" lesson.  The futures contract for the game, a price freely negotiated in a free market, makes the odds of a Dolphin victory to be about 13-1.  Let us suppose that your own analysis showed that the "correct odds" were only 9-1.  Making an investment in Dolphin futures has two characteristics:

  1. It has significant edge.
  2. You will probably lose on this specific occasion.

Black Swan bets are long-range propositions.  One cannot expect to win on a specific occasion, but the advantage over time is huge — assuming the analysis is correct.  The point is that we can never evaluate the system based upon a single choice.  It can only be judged after many similar situations have occurred.

Finding Black Swans

One illustration of the approach to extremely unlikely events is an annual exercise by Doug Kass.  Each year he comes up with an out-of-the-box list of predictions that are non-predictions.  They are non-predictions in the sense that any particular example might seem unlikely.  By listing it, Doug suggests that it might happen, with odds greater than the market might believe.  If the investor can find a way of playing for these events, it might be a cheap shot.  His record this year has been very good.

Unlikely Events

The market also has problems in dealing with events that are unlikely, but have a more substantial probability than the black swan.  We challenged our readers with an example designed to make them think.  Foremost among these is the chance of a recession, and the accompanying prediction of a significant market decline.

Please note that this is a more specific prediction.  It should be accompanied by a time frame.  Most economists use a one-year forecast.  For the market prediction to work, the prediction must also have a market consequence.  If the recession forecast is reflected in earnings projections and stock prices, one could be right on the recession question and wrong on the market.

There is always a chance of a recession.  In a given year, the chances are about 20%.  When economic growth is already at a reduced pace, the odds are higher.

Evaluating the Prediction of Unlikely Events

In past articles we have tried to explain the difference between a specific prediction and discovering "edge." Non-economist pundits frequently criticize the economic community for a failure to predict recessions.  This is a serious error.  Recession forecasting is probabilistic, not a 100% call.

A Forecasting Exercise

Economists (on average)  place the odds of a recession in the next year at  35% or so.  Some  range higher  and some much lower.  Non-economists and the public put the odds much higher.  Let us consider this  using Eddy’s example of the NFL.  There are several games where the  odds of winning are  about 20%.  Let us suppose that you believed these odds to be 35%.  You would have edge if making many predictions, but you would expect to lose each specific bet.

Here are the games where the odds are about 4-1:

Arizona versus Washington
Atlanta versus New Orleans
St Louis versus Seattle
San Francisco versus New York Giants

The question is whether any respectable pundit would predict a victory for any of these underdogs.  He would usually lose and seem foolish, even if he had significant "edge" on the odds.  One of these teams will probably win.  (St. Louis?)  Despite the likelihood that one will win, it would be poor form for a pro to pick any of these big underdogs.


A specific forecast has an outcome and a time frame.  Even after one knows the outcome, it is impossible to know whether the forecast was good.  It is one specific result out of many possible outcomes.

Investors who listen to those asserting certainty about a recession are making a mistake.  No one can do this.  Similarly, criticism of economists for using probabilities is wrong.  Understanding the concept of "edge" and what is already reflected in market prices is crucial.  Any trader or investor who does not understand this is operating at a big disadvantage.

Black Swan events are a bit different.  These non-specific forecasts are relevant, yet not specific.  The investor needs to consider ways to allow for these possibilities while not allowing them to determine the overall investment posture.

You may also like


  • VennData October 21, 2007  

    Another excellent post. Some comments:
    Eddy E claims the Pats/Fish spread is high and wonders how the handicappers will deal with this.
    The problem is ‘the line’ is ‘set’ to bring half the money to one side, half to the other. This is not like fundamental investing, but more like day-to-day market makers taking orders: Graham’s voting machine versus a weighing machine.
    The ‘line’ or ‘spread’ is distinguished from the odds which want a four to one ratio of money on either side. While a reader with a superficial understanding of odds, Vegas, bookmaking etc. will claim that this is a theoretical difference without a distinction, there is a critically important point: the 4-to-1-type wagers on American football in Nevada usually have a higher vig (vigourish, yiddish for ‘fee’) than a standard ‘line’ bet.
    Why is this? Is it that they’re newer? Or that the house can ‘fit’ that extra vig in a little easier?
    Bettors driving in from SoCal or flying in from the East Coast are used to the line, not odds (nor teasers for that matter and all those “fun” bets on the Super Bowl… big vig..) So while I agree gaming – not gambling – provides a simplified model for investors, my takeaways are as follows:
    1) Liquidity effects investing.
    Why does EEM have over four times the capitalization of the virtually identical but much… much less expensive VWO? Built in capital gains should mean old holders of EEM do NOT trade. Academics have found a tracking error differences of 45 basis points between EEM and VWO. EEM charges 75 basis points… VWO charge 30… hmm… Spreads vary but are pretty much a penny. Is it because they’re newer like the “odds’ bets on football? Or because the fees are imbedded like the “odds” bets in football?
    Also, even though you’re paying that huge 10% vig – paid back if you cover – you can’t legally lay off (read hedge) your bet (betting the second half is an independent event.) So that liquidity risk is akin to a subprime mortgage in fall of ‘07… There’s just no secondary market…You can’t resell your wager.
    So why does anyone buy EEM versus VWO? Because they do.
    2) Anything can happen.
    So you bet the sure thing, you took the Pats to “beat” the Fish giving the points. Imagine how you felt when they pulled Brady? Those poor favorite bettors; they must have freaked out worrying about their seventeen point spread (did they then hope Belichick would revert to form and start stealing signals again?) Then, when they brought Brady back in? Who would have guessed that? End result: The Patriots covered, barely.
    3) The most important thing in betting is the vig.
    What gaming – sports betting, craps, poker, etc. – taught me was the vig is the crucial element. If you bet all the NFL games on any given Sunday (incl. Thurs – Monday Nite) you’ll win some, you’ll lose some. They’re all 50/50 propositions, except… you pay to play, a lot. Any given weekend of random betting and you’ll lose your vig. So…
    Buy VTI, VGK, VPL, VWO and de facto rebalance using VFIFX and you’ll be way ahead of the game in thirty years…. I predict (now, how you allocate among them is a different post.)
    4) Finally, when visiting Las Vegas bet against the Dodgers and Trojans. The SoCal money that flows in tends to support their teams, the lines are “set” accordingly.

  • phyron October 22, 2007  

    I think you’re missing the point… and are a bit confused bout the difference tween betting and investing..
    a) Obviously there is none
    b) When you talk about 35% probability of winning your defacto talking about 65% probability of losing..
    c) One man’s put is another man’s call
    d) The basis of most rational investing and risk management.. the Kelly Criterion is explicitly phrased and derived in terms of bets…
    e) If you were presented with a series of bets at say 35% and on average you were right 45% of the time you would be the most successful investor in history.

  • RB October 22, 2007  

    There is a very clear difference between gambling and investing. While gambling is biased in favor of the house, investing has always produced positive real returns over any 20-year period over the last 80 years.