Thinking the unthinkable and describe the unknown is the hallmark of scenario analysis and may be more important today than in the past during the period of the economic Great Moderation. Analysts will be made more for making the right decisions in an uncertainty world. Call it the period of Tail Risk Thinking.
A recent conversation with a broker focused on the issue of tail risk. He said that everyone is talking about it, but I had to ask the simple question, which tail. I don't know whether I have to be worried about being too pessimistic or too optimistic. Under a pessimistic view, I have to worry about the continued slow work-out of the credit excesses in the economy. The tail risk is that US and global growth climbs in 2011. Under an optimistic view, the downside worry is that there will be a continued credit drag on growth. The tail risk is the opposite of whatever you may be thinking.
A recent conversation with a broker focused on the issue of tail risk. He said that everyone is talking about it, but I had to ask the simple question, which tail. I don't know whether I have to be worried about being too pessimistic or too optimistic. Under a pessimistic view, I have to worry about the continued slow work-out of the credit excesses in the economy. The tail risk is that US and global growth climbs in 2011. Under an optimistic view, the downside worry is that there will be a continued credit drag on growth. The tail risk is the opposite of whatever you may be thinking.
Hence, scenario analysis can be very important to frame downside risk and understand the assumptions surrounding views. While I am strong proponent of systematic investing, high uncertainty lends itself to more weight on scenarios. This will be the unknown or non-measurable risks.
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