Taking uncertainty seriously6 December, 2016 at 18:46 | Posted in Economics | Leave a comment
Conventional thinking about financial markets begins with the idea that security prices always accurately reflect all available information; it ends with the belief that price changes come about only when there is new information. Markets are supposed to reflect new information quickly and efficiently, albeit with a few anomalies.
In 2007, I interviewed over 50 investment managers mainly in New York, Boston, London, and Edinburgh. Talking to them I came to the conclusion that conventional theories of finance miss the essence of market dynamics. Information is usually ambiguous and its value uncertain. When information is ambiguous and outcomes are fundamentally uncertain, decisions are not clear cut. They necessarily rely on human imagination and judgment, not simply calculation. Human imagination and judgment are impossible without human emotion. Conventional theories of finance, which ignore emotion, are therefore a very poor basis for understanding and policy.
“As long as we neglect emotion’s role in financial markets, and fail to understand and adapt to dimensions of human social and mental life that influence judgement, financial markets will be inherently unstable.”
Uncertainty and ambiguity are what make financial markets interesting and possible. They generate feelings that manifest in exciting stories, problematic mental states and strange group processes. As long as we neglect emotion’s role in financial markets, and fail to understand and adapt to dimensions of human social and mental life that influence judgement, financial markets will be inherently unstable. They will also be likely to create poor outcomes for ordinary savers and significant distortions in capital allocation – exactly what we have been witnessing in the market today.
The uncertainty to which I refer can be termed radical, fundamental, Knightian or Keynesian uncertainty. I use these descriptions to stress the fact that, although we can imagine the future, we cannot know it in advance. My interviewees collectively risked over $500 billion every day. Every one of the positions they took depended on interpreting ambiguous information and each would be vulnerable to unforeseen events. Consider the present possibilities that the Euro crisis will lead to a return to national currencies, and that disputes in the US congress will lead to problems meeting US debt obligations. What the existence of such possibilities will do to the prices of commodities, currencies and securities over the next thirty-six months, and what different financial decision-makers will think about it, is not knowable – and there will be many more unexpected developments with significant ramifications.
Decisions made in a radically uncertain context are totally different in their implications from decisions made in conditions of risk modelled as a Gaussian probability distribution. A Gaussian model constrains future probabilities, thereby creating known unknowns. The outcome of decisions becomes predictable and what is rational becomes clear. Under radical uncertainty this is not the case. What will happen tomorrow involves far more complexity and interaction than can be captured by analogies to games of chance. Taking radical uncertainty seriously, therefore, changes everything.