An investor's lesson from Hurricane Sandy

Try this.

Find a news article from before this week discussing the biggest risks that the American economy faces later this year. There are hundreds of them. Most focus on three big concerns: Europe, the fiscal cliff, and an earnings slowdown.

But not a single one says anything about what is likely to be the biggest ding to growth over the next three months: Hurricane Sandy.

Sandy could lop 0.6 percentage points off fourth-quarter GDP growth, according to IHS Global Insight. For an economy growing at 2%, that's huge — likely the most significant single event to hit the economy so far this year.

No economist or analyst saw this risk coming prior to just a few days ago. They couldn't know, because it was unknowable. And that's a great example of what risk really looks like.

"Risk is what's left over after you think you've thought of everything else," writes financial advisor Carl Richards. The biggest risk usually isn't the stuff making news; It's the stuff that no one is talking about and no one sees coming.

The best example of this came eleven years ago. Here's a sentence from a news article from September 8, 2001: "[Economists] acknowledged that risks remain, chief among them the continued decline in corporate profits." Think about that. Seventy-two hours before the 9/11 terrorist attacks, the top worry on economists' minds was dwindling corporate profits. Obviously, no economist could have possibly known that a risk magnitudes greater was hours away. But that's the point: Risk is what's left over after you think you've thought of everything else.

When I heard IHS's estimate of Sandy's impact on GDP, I thought about the thousands of economists — many of them brilliant minds with PhDs — who spent countless hours forecasting what the economy will do for the rest of the year. Because of Sandy, every model and prediction they made before the hurricane hit is void. It's wrong. It's, basically, useless.

That's not a criticism of economists' inability to predict a freak weather storm. It's a criticism of how they — and so many of us — view the value of predictions in a world that's so risky and unknowable. In his book, The Black Swan, Nassim Taleb wrote:

The inability to predict outliers implies the inability to predict the course of history … But we act as though we are able to predict historical events, or, even worse, as if we are able to change the course of history. We produce thirty year projections of deficits and oil prices without realising that we cannot even predict these for next year — our cumulative prediction errors for political and economic events are so monstrous that every time I look at the empirical record I have to pinch myself to verify that I am not dreaming. What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it.

What can you do about it? Here's Carl Richards again: "Our assumptions about the future are almost always wrong. We can never think of everything — but we can take sensible steps to protect ourselves from life's inevitable surprises." For most of us, that means having a lot of liquid savings, and the willingness to adapt to new circumstances. "At its best, life is completely unpredictable," says Christopher Walken. And at worst, you're totally unprepared for it.

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