This is the third and final installment of the fundamental uncertainty in the finance series. The first two explored the origins of possible theories and errors of modern meaning.
Modern finance has tried in vain to transform the radical uncertainty that exists in our complex world into measurable risk using highly complex models. This error has profound consequences for the financial sector and the wider economy.
So how should we deal with fundamental uncertainties?
We can, of course, grasp the current method – denial – and the confusion that can be measured. We can call it a “once-in-a-century event”, a complete exception to the rules of our modeling world.
What is the effect of this mentality? As Nasim Taleb has described, we condemn ourselves for living a “fragile” life. Since these 100-year events repeat many times more than our model world predicted, we will be repeatedly frustrated by financial catastrophes, both large and small. Unable to integrate these disasters into our models, we will respond repeatedly in shock.
The so-called cautionary principle is another popular response to fundamental uncertainty. Accordingly, we should avoid all conceivable burdens and threats to our lives. So we refrain from doing anything that could lead to adverse consequences. In the field of environmental protection, the treaty of the European Union, in Article 191, has explicitly adopted this model, and great efforts are being made to achieve zero carbon dioxide emissions and phase out nuclear power. The precautionary policy has also affected the fight against Covid-1. Some preferred to keep the lockdown on until effective vaccines were distributed. Similarly, in the case of investments, many savers will initially exclude all possible losses by excluding equity from their portfolio.
Of course, guided by its logical conclusion, the precautionary principle is a recipe for paralysis. This means denying all our options for action since every action has the potential to have harmful consequences, even if it is remote. After all, every zero of the bread we eat has the potential to suffocate us.
John K and Marvin King, on the other hand, provided a good response. They believe that in the fog of fundamental uncertainty we must move forward with trial and error. The starting point is to diagnose the problem in the form of a mature “narrative”. This narrative takes into account all the familiar aspects of the issue and is consistent in itself.
On the basis of this narrative, we should consciously decide that they can always be questioned by new information, wonder. As the Prussian military strategist Helmuth von Molt told The Elder, “no plan of first contact with the enemy survives.”
Thus, we need to constantly review our descriptions and adapt them if necessary. Our decisions must leave some room for reconsideration. It then follows that we should be divided into a series of small problems to avoid all the problems or some choices.
Hope for the best, ready for the worst
In order to steel ourselves for the inevitable surprises, we need to build a culture to deal with them. This means exposing oneself to the possibility of positive surprises, such as maintaining Taleb, and preparing for potential negative shocks ahead of time so that their consequences are more manageable.
To this end, we should work to maximize the potential for positive surprises and mitigate the effects of negatives. How do we do that? By diversifying our actions and preparing the buffer, a margin of safety, those negative shocks should exceed our expectations.
What would it look like in the case of an investment portfolio? It has good prospects for future growth and companies carry adequate cash costs and it can take the form of a broadly diversified equity portfolio to avoid an emergency fire if markets sink. This way we can both seize the opportunities and “give” enough to the system to absorb potential black swan events.
This culture of wonder will not just serve the investor world. It will rise one step above the precautionary policy in health and environmental policy. In the fight against coronavirus, thesis insights have already gained ground: the priority of a flexible approach defined by cunning and experimentation to prevent the maximum risk of massive lockdown.
In environmental policy, on the other hand, we need to go a little further to uphold this philosophy. This may be some time before the emergence of a less cautious climate policy that is not strictly based on resistance. Such an approach would focus on global warming adaptation as well as resistance. It will have a diversified portfolio of energy sources that includes modern nuclear technology as well as renewable and more efficient fossil fuel applications. Emphasis on transportation innovation will lead to all kinds of propulsion other than electric. And this environmental policy will not completely discount, however remote, that perhaps science is wrong and humanity is not responsible for climate change.
The reality of fundamental uncertainty is that we cannot pretend to know what is fundamentally unknown. The rigid orthodoxy of modern finance has not given us hope or preparation for the dot-com bubble, the global financial crisis (GFC), the Covid-1 pandemic epidemic, or any other 100-year event. They will not prepare us for the next push.
That is why we need a new approach to risk. Whatever the concept of modern finance, we don’t really know of any special opportunity or the possibility of a catastrophe in the vicinity of the next catastrophe. So we need to be agile and adaptable, at the same time ready to take advantage of the unexpected good fortune and protect ourselves from the next black swan in the market. That means building a culture of wonder.
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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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