Ron Dembo is the founder and CEO of RiskThinking.ai.
September 11, 2001. The 2008 housing market crash. The COVID-19 pandemic. All of these events appeared almost out of nowhere and caused catastrophe and chaos in our country. These are all examples of black swan events—occurrences that are beyond prediction and cause extreme consequences, and that people attempt to rationalize after the fact. But are they truly impossible to predict?
Until now, black swan events have been considered unpredictable, but I believe we can change that by using the data we do have in a new way.
We Could Have Predicted The Globe’s Hottest Year
2023 was the hottest year ever recorded. At 2.12 degrees Fahrenheit hotter than the century’s average, 2023 set a new record for temperatures around the globe. Could we have predicted last year’s record temperatures and potentially prepared for the effects of scorching heat, such as crop failure, drought, storms, fires and heat-related human deaths? Yes—although not with historical data.
Data is the necessary ingredient when making predictions, but data from the past isn’t applicable because the circumstances of our climate are changing so rapidly. What we need is data from the future, which does not yet exist. Without the benefit of a time machine, our next best method of gathering theoretical future data is tapping into the wisdom of subject matter experts. In the case of predicting record temperatures, that means climate scientists, policymakers and researchers.
If we had asked 1,000 scientists to predict the highest possible temperatures for the next three years, we likely would have gotten 1,000 different answers. These would be educated guesses, but it’s the “educated” part that outweighs the “guesses” portion of the phrase. These predictions would be based on the culmination of years of study, training and science. Take these 1,000 educated guesses and map them out as a distribution, and the resulting graph would likely cover the actual record temperatures we saw in 2023. This method of prediction is referred to as the stochastic method.
Stochastic Versus Deterministic Models
Forecasting, which is a deterministic method of making predictions, uses historical data to predict what could happen in the future. Forecasting is used in business, science, economics and more. But in the case of black swans, what we are trying to predict is so rare that historical data has limited usefulness.
But with a stochastic model, the result is a distribution. Therefore, there’s a greater chance to hit the right number because distributions include a range of answers, and the black swan is likely to fall in that range. Distributions are a shotgun approach to hitting a target rather than the laser-focused approach of a forecast.
The stochastic method can reduce uncertainty because it eliminates blind spots. It illuminates a larger data set, allowing us to see a wide array of potential outcomes, which increases the probability of spotting black swans before they happen.
Use The Stochastic Model To Prepare For Any Scenario
Worst-case scenarios are no longer only the provenance of blockbuster movies. In an era of increasingly extreme climate events, a pandemic that put the entire world on hold and economic crises shifting the landscape for future generations, it’s clear that our world can and does change overnight. Companies and governments must have plans in place even for the most unbelievable events. Just as firemen are always training for worst-case scenarios, and NASA puts its astronauts through endless exercises because there’s no room for error in space, you should be planning for the unexpected, too.
While we can’t accurately predict when and where a black swan will strike, we can hedge against it by using the stochastic method and planning ahead. In business, this may mean planning for what your company would do if rail lines shut down in high temperatures. In real estate, that could mean installing air conditioning units in your multifamily property that historically have never needed them so your tenants don’t suffer in a freak heat wave. Think about what types of black swan events could affect your business, then get together with stakeholders and leadership and start making plans. Hopefully, these are plans that will go in a file, never to be used again. But if you do need them, they could save your organization from certain failure.
We’ve Always Hedged Our Bets
Our ancestors couldn’t predict when a storm would hit and wipe out crops, but they hedged their bets by storing grain in times of abundance for use in lean times. We can do the same. Now is the time to gather data, use the stochastic model to create a distribution of possible threats and create contingency plans and take out insurance policies to hedge your bets. If worse comes to worse, you’ll be glad you did.
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