Thomas McCrae, an early 20th century physician, once wrote about diagnosing a patient with a common abdominal disease.
McCrae's teacher — far more experienced — examined the patient and came to a different conclusion. He diagnosed an extremely rare disease McCrae had never heard of.
The only way to determine which diagnosis was right was to perform surgery. So they did, and the common ailment McCrae suspected was indeed what the patient had.
In his essay The Method of Zadig, McCrae noted that the only reason he didn't consider the rare diagnosis is because he had never heard of it, so in a way he wasn't burdened by looking for it. That let him put higher odds on the more common — and ultimately right — disease. He wrote:
It's hard to overemphasize how much this applies to investing, especially investing commentary.
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Two important things happened in the last decade. One, we had a terrible financial crisis. Two, the market for investing commentary became more competitive.
Both forces turn analysts into McCrae's teacher: The power of a financial crisis is fresh in our minds, and the prize for predicting the next financial crisis in a hypercompetitive media market is enormous. McCrae described the doctor as being "very proud of having diagnosed a rare abdominal disease," which also describes the investing pundit who will make a name for himself predicting the next meltdown, not the next average year.
As a result, a lot of analysts discount the odds of average recession, an average bear market, or average growth. At every corner, they see the rare diagnosis of extremes. Just look at the headlines:
There's a paradox here: The entire reason we pay so much attention to the 2008 financial crisis is because it was rare, but paying so much attention to it makes us overweight the odds of it happening again. Even when an analyst means well and isn't looking for attention, we turn into McCrae's teacher: Discounting the odds of common in favor of something far less likely.
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In both medicine and investing, you may want someone who obsesses over outliers. Black swan events shape the world, after all. But there's a difference between respecting outliers and seeing them around every corner.
I want a doctor who is vigilant about cancer risks, but not one who will biopsy every freckle, because that could have side effects greater than the disease itself. (Mammogram guidelines were recently changed for a similar reason.) And I want to listen to an investment analyst who takes the power of deep recessions seriously, but not one who thinks every blip is the second coming of the Great Depression.
The whole wisdom of black swans is that people underestimate their impact. But overestimating can be just as dangerous. Accurately diagnosing a rare disease might not be an accomplishment if you made 100 dangerous false-positive diagnoses before it. And accurately predicting a financial crisis isn't an accomplishment if you spent your whole career before it falsely predicting doom. Even at the bottom of the Great Depression, stocks fell back to where they were in 1924, five years before the peak (adjusted for dividends and inflation). So anyone predicting doom five years too early would have been better off just living through the market crash of the 1930s rather than avoiding it. As the saying goes, more money has been lost preparing for bear markets than in actual bear markets.
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The takeaway is something that sounds blindingly obvious but analysts, based on their forecasts, clearly forget: Rare is rare, so we should expect more common events to have a higher probability of occurring.
The next recession may be worse than 2008, but it's far more likely to be something that reduces GDP by a percentage point or two and raises the unemployment rate to around 7%. It could be over before most people realize it began. And, sure, the next bear market could be like 2008, when stocks fell more than 50%. But it's more likely to be something that pulls stock prices down 20% to 30%. If that's the case, we're already halfway there.
Or, as McCrae put it when advising doctors: "It is the simple things which require to be kept constantly before us and which must form the foundation of our diagnostic ability."