Does anyone remember Bird Flu? Apparently we were all going to die from it last year. How about the Ebola Virus that was destined to spread around the world like a 21st Century plague? Indeed on the 1st of January 2000 we were due to be plunged into darkness as the “Year 2000” (YTK) bug rendered all our computers, lifts and toasters useless.

We read about all these in the press, TV programmes spoke in grim terms of the threat that lay before us. In the case of YTK regulators issued special notices requiring firms to undertake specific business continuity planning. Yet we are still alive, our computers worked as well on the 2nd of January as they did on the 31st December. In the words of Monty Python we are “not dead yet”.

In general we are remarkably bad at predicting the future. Yet we pay vast amounts to people who claim to be able to. Here I am not referring to the tarot card readers or crystal ball gazers but to the business professionals. The stock analysts, the market forecasters and their complex computer models. Some regulators, such as the UK FSA, even produce an annual “forecast risks outlook” which firms are requested to take into account in their own business planning.

In researching a paper for the last meeting of the Financial Services Commission board I had cause to look again at the FSA’s outlook paper for 2007. There was, as it turned out, a fair bit on bird flu. Yet, funnily enough nothing on the risk of the credit crunch that swamped the financial world a few months later. There was a bit on liquidity but it was more the vague warnings of a horoscope nature ( “on Tuesday you will receive a surprise”). So how come the FSA, with all its resources failed to foresee the most dramatic financial event in decades?

So why do we fail to predict some things, yet plan so hard for other events that never occur? Firstly most of us are rubbish at probability. If we weren’t we would never play the lottery. If you toss a coin in the air and it comes down heads ten times, the odds of it doing so the next time is fifty:fifty, yet we act (and occasionally bet) as if after ten heads it is bound to be tails. Some people are terrified of flying, they believe it to be dangerous. Yet car travel is far more risky. We consider ourselves a rational species but we so frequently fail to demonstrate this in our actions.

Secondly we are bad at predicting because we think we are good at it. We vastly overestimate our success at it. We put good luck down to our skill but leave bad luck where it is as bad luck. In the financial world this is magnified. Take ten fund managers. In any given year some will outperform the average. It doesn’t mean they are good, It is simply that someone has to outperform the average (unless they are all average) because it is an average! Yet firms boast the success of their outperforming managers, they pay them huge bonuses. Successful hedge funds charge vast fees, and relate to potential investors at length as to how their strategy paid off. Some clearly are skilled, many more are simply lucky, they did the equivalent of guessing a coin toss correctly five times in a row.

I am not decrying prediction and planning, it is a vital part of business, I am simply saying that it has its limitations and it is equally vital that we take those limitations into account. In the words of Donald Rumsfeld “the unknown unknowns”.

The truth is that some events, often the most important ones, are not possible to predict.. They are outliers. In the words of Nassim Nicholas Taleb, they are “black swans” . Hindsight will always allow is look back and see how something could have been avoided, but the truth is that, in reality, it could not have been foreseen.. Indeed the fact that such events cannot be predicted makes their impact all the more extreme.

Elements of the credit crunch were, in my view, simply not predictable, books will be written on how we should have seen it coming but they have the benefit of post event rationalisation. I say elements as, the ultimate impact of some of the actions leading up to it were not merely predictable, but inevitable. Lending vast amounts to people who could not hope to pay it back has pretty obvious consequences.

In respect of black swan events prediction is, by definition, pointless. The key is to accept their existence, and therefore the resulting limit to our ability to predict and adjust our lives accordingly. One group that does is the casino industry. The casino industry knows probability, they make their money on it. They know some players will win and some will lose. Winners are encouraged, they act as a beacon of hope to the losers. (indeed if they believe in their own skills rather than luck they may just become losers next time). What the operators generally don’t want is a black swan. Someone who arrives places vast bets, gets lucky each time and cleans them out. They therefore often set betting limits. No limit games are generally those where players bet against each other, not the house. Bookmakers lay off large bets onto other bookmakers so reducing their exposure.

The insurance industry operates on a similar basis. Firms reinsure to reduce their exposure to a black swan event.

So how can other firms build such adjustment into their business planning. How can you build in something highly probable but with a high impact. The key lies in not looking at the event, but what high impact would be in the firm. Putting it simply, what three things would kill your firm and plan back from there.