Effect, n. The second of two phenomena which always appear together in the same order. The first, called a Cause, is said to generate the other – which is no more sensible than it would be for one who has never seen a dog except in pursuit of a rabbit to declare the rabbit the cause of the dog. – Ambrose Bierce, The Devil's Dictionary

The purpose of this chapter

Extreme events or, more generally, user-specified scenarios that describe atypical market conditions play a central role in the approach to asset allocation described in this book. As we shall see, our procedure requires the portfolio manager to assign conditional probabilities to the events that connect causes and effects. However, before assigning probabilities, one must identify the potential consequences of a certain conjunction of events. In particular, in order to get the procedure started, the asset manager must be able to specify what the potential consequences of a given extreme or unusual event might be. This brings into play the vexed questions both of predictability and causation, and of what an extreme event is. We briefly look at both questions in this chapter.

Before delving into a discussion of predictability and forecasting, it is important to clarify one aspect of our approach.