Rare events are by definition events that happen with a very low frequency. Frequent examples of the literature are large tsunamis, earthquakes and the impact of an asteroid. However, the rare event to us is a financial crisis. Rare events exert so much fascination not because they are rare but also because they are difficult to predict, making whoever does it - by luck or not - the next great guru for a few months or even years.
I intentionally used the term "luck" because according to the efficient markets hypothesis, any financial crisis is practically impossible to be predicted, being practically impossible to make money trying to predict what will happen next in the markets. Consequently, when you get it right, it's nothing more than a coincidence of facts.
An interesting point here is that perhaps will never be possible to predict exactly when a crisis will happen, but it is possible to understand that a crisis is imminent with a certain degree of probability - which always brings us a certain degree of uncertainty as well. The problem lies in ignoring the degree of uncertainty and finding that only a high probability is a "guarantee" of occurrence of a particular event. Toss a coin 100 times gives you a high probability of a certain amount of "heads" happening - close to 50% - but nothing prevents you from having 100 "tails" in a row. Okay, it's rare, but nothing says it cannot happen.
Let's do a practical test. Check on the chart below the results from a 1000 coin tosses simulation.
A simple simulation of tossing a coin 1000 times, using Microsoft Excel (for the sake of the argument, lets forget questions such as if the RAND function is random and what is randomness), shows us in the following chart an idea of what can happen. In this example, in 1000 "tosses", a sequence of 15 heads (maximum value in a row obtained) occurred 2 times and in 16 times we had a sequence greater than 10.
What do we conclude from this, and what does this have to do with investments or trading?
The first point here is the fact most ignored by the beginners: "this stock has already gone up too much, it has been going up for 10 days ... it will go down, for sure". As we saw above in the coin toss example, if the coin were an stock share and the "head" was a bullish day, we saw that the stock would have gone up "15 days in a row", twice in a period of 1000 days. And we cannot forget that we had 16 times with more than 10 hypothetical bullish days.
This leads us to the second point: is it possible to profit from this? Yes, but never neglect the fact that we can perhaps have one single time 15, 20, or 30 heads in a row. But don't forget that your risk:return ratio, that is, how much your bet is worth is more interesting every time. It is guaranteed? Never will be...especially if the events are independent, like the toss of a coin ... but in markets, where everyone will probably be "seeing" the same event and trying to anticipate what will happen, we have the effect of the self-fulfilling prophecy. This would prove once again the efficiency of the markets and the impossibility of predicting it. One may try to predict something...but taking this guy seriously is another talk.
Finally, the third and final point is that crises are impossible to be predict, since they are examples outside of any sample - outliers. They never happened before, so it would be impossible to try to predict what never happened...it would simply be impossible to calculate the probability. Returning to our example of the 1000 tosses, how to calculate the probability of occurrence of 17 heads in a row if this never happened before?
Lets wait for our next posts!