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The Dangers of Seeing a Market Crash at Every Corner

Thomas McCrae, an early 20th century physician, once wrote about diagnosing a patient with a common abdominal disease.

McCrae’s teacher — far more experienced — examined the patient and came to a different conclusion. He diagnosed an extremely rare disease McCrae had never heard of.

The only way to determine which diagnosis was right was to perform surgery. So they did, and the common ailment McCrae suspected was indeed what the patient had.

In his essay The Method of Zadig, McCrae noted that the only reason he didn’t consider the rare diagnosis is because he had never heard of it, so in a way he wasn’t burdened by looking for it. That let him put higher odds on the more common — and ultimately right — disease. He wrote:

“The moral of this is not that ignorance is an advantage. But some of us are too much attracted by the thought of rare things and forget the law of averages in diagnosis.

There is a man who is very proud of having diagnosed a rare abdominal disease on several occasions. But as for some years he made this diagnosis in every obscure abdominal condition, of course being nearly always wrong, one cannot feel that he deserves much credit.”

It’s hard to overemphasize how much this applies to investing, especially investing commentary.

Two important things happened in the last decade. One, we had a terrible financial crisis in the West, leading to an epic stock market crash in Singapore – the Straits Times Index (SGX: ^STI) fell by over 60% – and in many other parts of the world. Two, the market for investing commentary became more competitive.

Both forces turn analysts into McCrae’s teacher: The power of a financial crisis is fresh in our minds, and the prize for predicting the next financial crisis in a hypercompetitive media market is enormous.

McCrae described the doctor as being “very proud of having diagnosed a rare abdominal disease,” which also describes the investing pundit who will make a name for himself predicting the next meltdown, not the next average year.

As a result, a lot of analysts discount the odds of average recession, an average bear market, or average growth. At every corner, they see the rare diagnosis of extremes. Just look at the headlines:

A recession worse than 2008 is coming

100% Chance of Crisis Worse Than 2008

The table is set for the next financial crisis

The next crisis will be worse than 2008

Sell Everything’: Global Bank Warns Investors of Coming Financial Crisis

There’s a paradox here: The entire reason we pay so much attention to the 2008 financial crisis is because it was rare, but paying so much attention to it makes us overweight the odds of it happening again. Even when an analyst means well and isn’t looking for attention, we turn into McCrae’s teacher: Discounting the odds of common in favor of something far less likely.

In both medicine and investing, you may want someone who obsesses over outliers. Black swan events shape the world, after all. But there’s a difference between respecting outliers and seeing them around every corner.

Wanting a doctor who is vigilant about cancer risks makes sense – but not one who will biopsy every freckle, because that could have side effects greater than the disease itself. (Mammogram guidelines were recently changed for a similar reason.) Following the same logic, wanting to listen to an investment analyst who takes the power of deep recessions seriously is sound – but not one who thinks every blip is the second coming of the Great Depression.

The whole wisdom of black swans is that people underestimate their impact. But overestimating can be just as dangerous. Accurately diagnosing a rare disease might not be an accomplishment if you made 100 dangerous false-positive diagnoses before it. And accurately predicting a financial crisis isn’t an accomplishment if you spent your whole career before it falsely predicting doom.

Even at the bottom of the Great Depression, stocks in the U.S. fell back to where they were in 1924, five years before the peak (adjusted for dividends and inflation). So anyone predicting doom five years too early would have been better off just living through the market crash of the 1930s rather than avoiding it.

Similar cases have happened in Singapore’s stock market too during the Great Financial Crisis of 2007-09. At their troughs during the crisis, Vicom Limited (SGX: V01) and Dairy Farm International Holdings Ltd (SGX: D01) both had higher share prices than at the start of 2006.

As the saying goes, more money has been lost preparing for bear markets than in actual bear markets.

The takeaway is something that sounds blindingly obvious but analysts, based on their forecasts, clearly forget: Rare is rare, so we should expect more common events to have a higher probability of occurring.

Or, as McCrae put it when advising doctors: “It is the simple things which require to be kept constantly before us and which must form the foundation of our diagnostic ability.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. This article was written by Morgan Housel and first published on fool.com. It has been edited for fool.sg.