“Failing to forecast rare events” by Prof. Philip Bond
Prof. Philip Bond
Professor of Finance and Business Economics
Foster School of Business
University of Washington
We analyze the allocation of trading talent across different types of assets, taking into account equilibrium considerations in both labor and financial markets. We identify a strong economic force that leads the highest-skill traders to focus on trading “common event” assets that pay off frequently. Less talented traders instead trade “rare event” assets that pay off only rarely, so that short positions pay off with high probability, i.e., “nickels in front of a steamroller” strategies. This allocation of talent leads to higher bid-ask spreads in common event assets, and reduces the ability of financial markets to predict rare events.