Risk and Five Sigma Events – Can They Happen to You?

May 24, 2011
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Perhaps it’s a sense of optimism wired into humans (or conversely delusion), but when business managers think of worst case scenarios, a common refrain is, “it could never happen to me.” Unfortunately, world events such as the Sendai Tsunami (natural disaster) or the Financial Crisis of 2008 (man-made disaster) highlight disastrous occurrences happen more frequently than we tend to believe.

Perhaps it’s a sense of optimism wired into humans (or conversely delusion), but when business managers think of worst case scenarios, a common refrain is, “it could never happen to me.” Unfortunately, world events such as the Sendai Tsunami (natural disaster) or the Financial Crisis of 2008 (man-made disaster) highlight disastrous occurrences happen more frequently than we tend to believe.

Some “rare” events have a large impact. Case in point, after losing a $400 million bet on oil futures, a hedge fund manager recently lamented; “The move in Brent represented about a 5 standard deviation move, while WTI (Texas Light Sweet Crude) was a 4 standard deviation move”.  The Financial Times commented that, “A five standard deviation daily move is an exceptionally rare event.”

Editor’s note: Paul Barsch is an employee of Teradata, a sponsor of The Smart Data Collective.

In another case study, Michael Lewis’ “The Big Short”, documents how one very large investment bank sold millions of dollars in credit default swaps (CDS) to a small group of hedge funds.  The hedge funds were betting that housing prices would fall and the market for subprime bonds would collapse. The investment bank was more than happy to insure against the collapse of these bonds because they believed default swaps were “free money”—after all such a collapse had never happened before.

Once risk managers in the investment bank discovered the huge exposure to the collapse of mortgage bonds, they pressured the issuing trading desk to “stress test” their portfolio.  A senior manager in charge of the stress tests said, “(The trading desk) didn’t want to show the results of the stress test. They kept saying that state of the world can’t happen.” 

The story ends in a gruesome fashion. That particular “state of the world” did occur, and the investment bank was on the hook for a billion in subprime losses. 

Author Satyajit Das in “Traders, Guns and Money” comments on the “it can’t happen to me” point of view; “Nobody thinks they will be at sea in the perfect storm, nobody believes they will be in the lowlands when the one in ten thousand year flood happens.”

Perhaps this mindset derives from the Illusory Superiority concept which Wikipedia states is a; “Cognitive bias that causes people to overestimate their positive qualities and abilities and to underestimate their negative qualities, relative to others.”  This mindset shows up in countless surveys where most people believe they have superior driving habits in relation to others, or when 25% of a particular class believes they’re in the top 1%.

Five plus sigma events tend to happen more than we believe, especially because the real world rarely consists of independent outcomes—i.e. coin flips. In addition, there are many that argue as the world becomes more tightly connected and interdependent, the opportunities for positive feedback mechanisms increase, potentially leading to even larger impacts from so-called low probability events.

The “it can’t happen to me” mindset is pervasive, and this is dangerous, especially because as Nassim Taleb says, “History teaches us that things that never happened before DO happen.”

A better option then to a “head-in-the sand” approach is to posit that extreme events happen, and instead scenario plan as much as possible for such situations.

Question:

  • What other real world case studies exhibit a “it can’t happen to me approach”?