The Daily Update - Fat Tail Risks and The Premier League

Monday’s Premier League win for Leicester City was not only a great result for the team, supporters and those who kept and cashed in on 5000/1 odds (prior to the start of the season) for Leicester to take home the trophy - but also for economists and statisticians looking for popular examples to highlight the confounding challenges in forecasting unlikely events; or what is known as “tail-risk”. If we were writing a textbook, Leicester’s result would certainly be the choice example for teaching school kids the risks (and opportunities) of getting involved with such alluring but complicated estimations - today bookies begin paying out around £20m (of which £10m is losses - the largest ever loss on a single sports bet). Simon Clare from Coral writhed, "In the history of betting, certainly since it was legalised in 1961, a [single event] winner with odds of 5,000-1 has never happened."

But out of the 47 who placed bets on such long odds at one major bookmaker over half cashed out early and the remaining 22 punters were likely either supporters or spectacularly fortuitous.  Apparently the one professional economist that usually places a £20 bet on Leicester to win the League John Micklethwait (boss of Bloomberg News and former editor of the Economist) forgot to place it this year! And we’re not aware of any large early bets made purely on the basis of dispassionate analysis; most likely that is because such analysis wouldn’t have been particularly enticing. According to political, sports and economics forecaster FiveThirtyEight, “Since World War II, only one team - Ipswich Town, the 1962 top-flight champs - has had such a long climb over seven years to win the league title. And no team aside from Ipswich then and Leicester now has climbed two tiers so quickly before winning the title.”

Clearly the bookies got it wrong; for example initially judging the event half as likely as Gold touching $2,900/oz in 1 year or dollar-yen touching 325 within 5 years (both 2500-1) and 5 times less likely than the Green Party winning the next UK General Election (1000-1). Anyone who follows ongoing research on tail-risk - such as Nassim Taleb’s (of Black Swan fame) recent work on “The Law of Large Numbers Under Fat Tails” - knows just how complicated it should be. At the very least what should be learned is that our feel for improbable risks is often unreliable.

In the investment world such fat-tail losses can at least be mitigated in three obvious ways: diversification, collateral and compensation. When one factors for these three requisites certain low yielding paper across the western world’s heavily indebted countries offers insufficient tangible protection or incentive to seem attractive, in our view. The optimism of familiarity and past evidence of creditworthiness (certainly not applicable across all Western Europe) is, of itself, not sufficient solace for taking on such tail risks for such little reimbursement. According to our investment philosophy it is much more defensive to invest across a broad remit of investments that offer attractive value and spreads whilst providing the ongoing assurance of being a net creditor.