Slaying monsters, managing extremes

Slaying monsters, managing extremes | Daily Tribune

And it is not just prices. The enhanced habagat has resulted in more than a month of daily rains. Apart from the floods, the extreme weather has also resulted in multiple class suspensions, consequently leading to extended disruptions to learning. Even outside markets, extremes are the norm instead of the exception.

Thinking beyond the average

Because of this, we need to consider expanding our decision-making processes to put heavier weight on extreme movements rather than on our current knowledge.

A presenter in a short YouTube video I caught described this perspective in a statistical backdrop — today is the age of the standard deviation. What this means is that we cannot rely on the average or the mean to guide our decisions. Instead, we should be utilizing standard deviation as a supplement to how we approach problems.

Standard deviation (SD) is a measure of how far the data (like prices or rainfall) is from the mean. As a statistic, we count the number of SDs a data point will be from the mean or average.

A good chunk of data points would likely fall within one SD of the mean, indicating these events are highly likely. Events that are less likely are two SDs from the mean, and the last measure is three SDs (3SD), which are the least likely events.

It is the 3SD events that should be of interest to everyone because if you do not design or prepare for them, they are the type of events that can significantly alter the outcomes that matter.

The monsters in the tails

There is a quote from a Marxist philosopher, Antonio Gramsci, which goes, “The old world is dying, and the new world is struggling to be born; now is the time for monsters.”

Our world is undergoing substantial changes that are shifting regimes. The geopolitical power reset — from globalization to fragmentation, climate change, the rapid growth of AI, and many other global trends — is creating a new environment for future generations.

Regardless of the driver, this surge in extreme movements in all environments are the monsters that we fear. In statistical terms, these monsters are the fat-tail events: low-probability shocks that sit far from the average but can reshape lives, portfolios and institutions when they arrive.

How to respond

What do we do given the increased 3SD environments, statistically called fat tails? A useful response begins with acknowledging that these monsters exist — then designing life, balance sheets, strategy, and behavior around them.

Why build a house with a one-meter elevation buffer against floods just because the historical average flooding is only half a meter? If the worst flooding was one meter, design for 1.5 meters or two, depending on the topography. Be intentional when it comes to function and let form follow.

First, build scenarios with both extreme positive and extreme negative outcomes. Never assume that because something is improbable today, it is impossible tomorrow.

Second, where possible, hedge or acquire insurance. If you are afraid of peso weakness or Philippine inflation, buying US dollar assets could offer some protection. However, given that these monsters are global in nature, there is no guarantee that such a strategy will protect you from extreme events in the US.

Third, diversify when direct monster slaying is too costly or uncertain. Sometimes, the best way to address monsters is to hide via camouflage. Investors can do this through diversification. This is the reason we see central banks around the world buying more gold in recent years and not just relying on US dollar assets.

Finally, manage the emotional response. It is easy to be cynical about extreme events, but the goal is not to fear them. Rather than taking a “bahala na si Batman” attitude, focusing on preservation and/or profiting against/from extreme events is a skill that everyone needs to develop. Remember, extreme fear is also a monster to slay.

(Jose Mari Lacson is the director and head of Macroeconomics and Impact Investing in ATR Asset Management. He has a PhD in Economics from De La Salle University and is a doctoral student in Sustainability at the UP Open University.)