Custard Cream Risk – Compared to What???
It was recently revealed that the custard Cream is the most dangerous biscuit.
But his illustrates the issue with stand alone risk analysis. Compared to what? Last spring, there was quite a bit of concern raised when it was reported that 18 people had died from Swine Flu. That sounds VERY BAD. But Compared to What? Later stories revealed that seasonal flu is on the average responsible for 30,000 deaths in the US. That breaks down to an average of 82 per day annually, or more during the flu season if you reflect the fact that there is little flu in the summer months. No one was ever willing to say whether the 18 deaths were in addition to the 82 expected or if they were just a part of that total.
The chart below suggests that Swine flu is significantly less deadly than the seasonal flu. However, what it fails to reveal is that Swine Flu is highly transmissable because there is very little immunity in the population. So even with a very low fatality rate per infection, with a very high infection rate, expectations now are for more than twice as many deaths from the Swine Flu than from the seasonal flu.
For many years, being aware of the issue I tried to make a comparison whenever I presented a risk assessment. Most commonly, I used a comparison to the risk in a common stock portfolio. Was the risk I was assessing more or less risky than the stocks. I would compare both the average return, the standard deviation of returns as well as the tail risk. If appropriate, I would make that comparison for one year as well as for many years.
But I now realize that was not the best choice. Experience in the past year reveals that many people did not really have a good idea of how risky the stock market is. Many risk models would have pegged the 2008 37% drop in the S&P as a 1/250 year event or worse, even though there have now been similar levels of loss three times in the last 105 years on a calendar year basis and more if you look within calendar years.
The chart above was made before the end of the year. By the end of the year, 2008 fell back into the 30% to 40% return column. But if your hypothesis had been that a loss that large was a 1/200 event, the likelihood of one occurrence in a 105 year period is only about 31%. Much more likely to see none (60%). Two occurrences only about 8% of the time. Three or more, only about 1% of the time. So it seems that a 1/200 return period hypothesis has about a 99% likelihood of being incorrect. If you assume a return period of 1/50 years, that would make the three observations a 75th percentile event.
So that is a fundamental issue in communicating risk. Is there really some risk that we really know – so that we can use it as a standard of comparison?
The article on Custard Creams was brought to my attention by Johann Meeke. He says that he will continue to live dangerously with his biscuits.
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