As our economy continues its record run, one of the things we’re keeping an eye on is the probabilities of different economic outcomes going forward. When it comes to developing probabilities for different scenarios, one of the key statistical concepts economists utilize are confidence intervals.
Confidence intervals measure the probability that a population parameter falls between two values with the probability being defined typically as 95% or 99%. For example, a mathematician running a confidence interval for potential returns for an investment may state their findings as follows: given a 99% confidence interval, we expect the return will fall between – 3.7% and + 5.9%. This means that they are 99% confident the investment’s return will end up being somewhere between -3.7% and 5.9%.
Why does this matter? As we’ve often said before, it’s impossible to predict the future, which is one of the reasons why we don’t believe in trying to time the market. However, while we aren’t fortune tellers, we do believe in the benefits of probabilities. We don’t know when the market will turn but we can get a feel for where it may be headed based on changes in the probabilities of certain economic outcomes.
It’s important to understand that confidence intervals aren’t saying that a given percent of a sample size falls between two numbers. A 99% confidence interval of -5 to +10 is not saying that 99% of items sampled fell between -5 and +10. What it is saying is that we can be 99% confident that based on the sample, a given data point will fall between those two numbers. Furthermore, it’s also important to understand that even with a 99% confidence level, there’s still a chance that something could happen outside of those two valuables (otherwise it would be 100%). These tail events are important because they are the events that rock the markets and events that, while unlikely, are nevertheless events that we want to account for, particularly when it comes to planning for the future. If you’d like to learn more about how we account for those tail events in our financial plans, we invite you to give us a call.