According to Easton, Sherin’s presentation explicated a widely held misconception among educators that in forecasting, a company seeks to report the good news, not the bad. In reality, the goal is to reveal any information deemed pertinent to investors, which speaks to the pre-eminence placed on thorough, ongoing communication so as not to surprise analysts.
The conference pointed out the need to consider the interdependencies of events.
As for forecasting models themselves, the discussion of the models of extreme events from experts outside of accountancy challenged faculty to consider a broader range of possible outcomes. Some highlights include:
• Financial catastrophes, like natural catastrophes, happen quickly and for complex reasons.
George Sugihara, a marine microbiologist at the University of California, San Diego, is credited with being one of the first researchers to apply chaos theory to describe how models used to forecast sardine populations could also be used to predict short-term market fluctuations. Financial analysts tend to expect market change to occur due to a linear series of events, said Sugihara, who worked as a managing director at Deutsche Bank for five years. The truth is that any complex system, be it a fishery or an economy, can fail due to a complex web of non-linear forces acting in unison.
• If our response to hurricanes is any example, we’re not likely to remember the lessons of the current global financial crisis for long.
Despite all our experience with catastrophic weather events, we continue to put ourselves in danger and rack up enormous insured losses. Why do we under-prepare? The reason, said Robert Meyer, a marketing professor at the University of Pennsylvania’s Wharton School, is that either we don’t believe it will happen to us, or we don’t believe it will happen again. This head-in-the-sand approach appears to be hard-wired in humans, said Meyer, and applies as much to investing as to weather. We don’t learn from near-misses, and we under-invest in opportunities that only have long-term benefits. Plus we have selective memories: What erodes with time is not our perception of the likelihood of another event, but the perception of our vulnerability.
• Predicting athletic performance can help predict financial performance.
John Einmahl, a professor of statistics at Tilburg University, told the audience that he had calculated the optimal time at which a man or woman could run 100 meters (9.51 and 10.33 seconds respectively, both faster than current world records)—and that this same exercise could predict everything from what an object might sell for at an auction to the maximum daily negative market dip possible for a specific stock portfolio. Einmahl is a practitioner of a subset of statistics called extreme value theory, which uses extreme deviations from median probability distributions to calculate risk. Other examples he presented included forecasting insurance losses for a hurricane, the performance of the dollar against the euro, and how large a capital buffer a financial institution should maintain.
On the whole, Easton said the discussion of the extreme forecasting models provides academics with new ways to look at old questions. The conference pointed out the need to consider the interdependencies of events. “One thing that has constrained what we have done is that old models assume what is done at one company is independent of another company. We have not thought about the dependencies as a critical part of forecasting,” said Easton.
Other notable speakers at the 2010 CARE Conference included Professor Katherine Schipper, a 1996 Notre Dame Honorary Doctorate Degree recipient, currently at Duke University’s Fuqua School of Business, and Barclays Capital’s Matthew Rothman, who examined the impact of the International Financial Reporting Standards (IFRS) on forecasting models. Former Wall Street analyst Kenneth A. Posner also discussed findings from his recently released book, “Stalking the Black Swan: Research and Decision Making in a World of Extreme Volatility.” Slides and video of the sessions can be found at the CARE Web site.
—Robert S. Benchley is a business writer based in Florida.