Editorial: Pay-off method and the weather

Weather or more precisely the scientific study of the atmosphere – meteorology is an interdisciplinary field that seems to study anything and everything that has to do with the atmosphere. One thing that meteorologist study is the forecasting of tropical storms and hurricanes. Now, the key word “forecasting” brings us to our topic – the pay-off method and the weather. Weather forecasting in the modern sense means the collection of quantitative data about the current state of the atmosphere and the application of scientific methods and technology to predict how the atmosphere will evolve.

This actually does ring a bell, indeed if we look at the previous sentence and just replace the words “weather” and “atmosphere” with the word “markets” we get the following:

“Market(s) forecasting in the modern sense means the collection of quantitative data about the current state of the markets for a and the application of scientific methods and technology to predict how the markets will evolve.”

Now isn’t that kind of interesting… and surely enough the same kind of methods are being used for both, for weather forecasting and forecasting the (financial) markets.There are elaborate mathematical models for the forecasting of weather and the financial markets, run by supercomputers and data and inputs are collected 24/7 and automatically fed into these systems. There is a difference though: atmosphere is not a man made system, but the financial markets are.

Already during my lifetime the reliability of weather forecasts has become vastly better, these days the weather forecasts seem to be mostly right, the inaccuracy having to do with more on the timing of events (when it starts raining) rather than with the events (rain) taking place at all or not. But there are still sometimes days, when rain was forecast, but the skies shed nothing.

We can all have our own opinion about the reliability of the market forecasting (economic) models. My gut is that they are not as good in prediction as the meteorological models. This may be due to the fact that the weather is more predictable than the markets (as it is a natural phenomenon and cannot be affected by humans on the short term). I had a crack at that discussion in an editorial posted here in January – surely a slightly polemical editorial, but with the best of intentions (that pave the way…).

Well enough about that… what else is there, of interest?

I did find something “about the weather” that actually got me a bit excited, and that was finding out that the U.S. National Hurricane Center (NHC) of the National Oceanic and Atmospheric Administration (NOAA)¬† National Weather Service (NWS) uses what they call “forecast cones” to represent the probable track of the center of a tropical cyclone. [You just gotta love the acronyms]

These forecast cones are obviously of little use if they are presented only as numbers and especially of no use if they are presented without the context – what this means is that the good way to present the data is to visualize it, that is to “draw” the cones and preferably on a map background. Visualized they immediately tell us who should start thinking about finding their way to the basement.

Forecast cone of the tropical storm Dean Aug. 2007 from www.nhc.noaa.gov

The forecast cones are obviously the output from the forecasting (computer) systems that house the complex atmospheric models and they are updated as new information arrives. To be able to understand the accuracy of these predictions the NHS tells us that “Based on forecasts over the previous 5 years, the entire track of the tropical cyclone can be expected to remain within the cone roughly 60-70% of the time.” Link to some more info about the cone from NHC site.

I don’t know about you, but to me the cone looks similar to the “accumulation of the net present value scenarios” graph used in visualizing the intermediate results in connection with the pay-off method. We can also call this the” project NPV cone” – or “the cone of uncertainty for the investment project”. Even the “logic” of the two looks (and should look) the same: the further into the future we go, the wider apart the sides of the cone (minimum and the maximum possible outcomes) are from each other – the width of the cone grows the further into the unknown (further away in time) we try to forecast.

 Graphical presentation of the cumulative net present value, the NPV cone of a project

Now why did I get excited?

The storm forecast cone is easy to intuitively understand and it is being used to report relevant important information by a US government agency to millions of people on-line 24/7. The fact that the cone is an obviously “approved” visualization technique of the output from a mathematical computer driven atmosphere model (that most of us including me would not be able to understand at any detail without considerable study) that allows all of us to understand the output in seconds is just wonderful.

To me this is a corroboration of my thoughts about the benefits of visualizing the accumulation of the net present value (NPV) of a project in the way that the pay-off method likes to do it. It enhances the understandability of the possible “path” of the potential investment, while “honestly” showing the forecasting inaccuracy and that it grows the further into the future we try to forecast.

The moral of the editorial: Use the forecasted NPV cone visually to enhance understandability of the future of the investment and to support decision-making.

Mikael Collan