Bias Towards Extremity

Doom and gloomers have successfully predicted 500 of the last 3 recessions.  This is a humorous way of poking fun of the fact that soothsayers who predict extreme events may eventually be right but tend to inflate their projections.

Results tend to be more moderate than expectations. People tend to believe or lean more towards extremities.

What does this mean?

  • This is why some investors use strategies designed to take advantage of mean reversion–the tendency towards a price to revert to a historical average.
  • This is why people sell insurance because it makes sense, over a big enough sample of people, to cover the risk of extremities by studying the mean reversion tendencies of many behaviors. People demand insurance to be able to sleep at night and know they are covered in an extreme event.  Insurance makes sense for most individuals because they may not otherwise be able to cover a significant tail risk scenario. However, if someone knows that the odds are not stacked against them and they have sufficient resources, insurance may not make sense.