Monday, March 10, 2008

Markets and Uncertainty

This is not the best time to be recommending books to people. But, I thought that, given all the turmoil around, it would be worthwhile for us to remember some relatively recent works that might help us to regain some perspective on markets (financial and otherwise) and guide us back to the fundamental issues we have to deal with during times like these. It is all too easy to get caught up in personalities or specific situations and that, in my mind, is exactly what we don’t want to do. For example, Paul Krugman’s Op-ed piece in the New York Times on March 10, 2008, is an example of emotional reporting and needs to be tempered with a review of the basics on which market participants need to concentrate:

I have great admiration for former Treasury Secretary Robert Rubin and have found his book (written with Jacob Weisberg) titled “In An Uncertain World: Tough Choices From Wall Street to Washington (Random House: 2004) to be helpful in the sense that Rubin has apparently systematically applied the techniques of decision making under uncertainty to both business and governmental situations. (I, like a lot of other people, are waiting for his next book in which he will discuss his role in the recent events at Citibank.) In terms of dealing with uncertainty there are two important ‘take-aways’ from this book. The first is that uncertainty in pervasive in human decision making. The thing that differentiates one situation from another is whether greater uncertainty or less uncertainty applies. The second pertains to the methodology used: the decision maker must be try to identify all of the possible outcomes related to the decisions that are available to her or him; and the decision maker must, in some way, assign probabilities to each of the possible outcomes.

Of course, the methodology that Rubin proposes is not an easy one to apply, particularly when one is under stress and is having to deal with markets that can move quite rapidly. Difficulty, however, is no excuse for not attempting, even in a simple way, to deal with the uncertainty that the individual is facing. We must do our research, we must read a lot and listen to many different opinions, and we must then make the best effort we can. There are no objective criteria for determining a comprehensive list of possible outcomes and the probabilities to assign to each outcome: everything is ‘subjective’. Intuition and experience are important factors alongside knowledge and skill.

Another book that is helpful in understanding the process of decision making under conditions of uncertainty is that of Michael J. Mauboussin titled “More Than You Know” (Columbia University Press, Updated Expanded Edition: 2007). There are several ‘take-aways’ from this book that should be remembered in dealing with uncertain markets. One of the first is that people tend to consider too narrow a range of potential outcomes. Thus, it is always relevant for people to expand their perspective and give attention to the possible outcomes they might otherwise exclude. It is a good discipline to force yourself to consider outcomes that you think only have a small probability of occurring. In doing so, you protect yourself from unintentionally eliminating outcomes that you might ordinarily dismiss from careful consideration.

A second thing that Mauboussin discusses which might be important in our analysis of uncertain situations is that all analysts and commentators will not be correct all of the time. Thus, we must not rely on one or just a few individuals for their view of the market. However, we should pay more attention to those analysts and commentators that have a higher ‘batting average’ than others. Even though we know that all will be wrong some of the time, those with a higher’ batting average’ will tend to have more ‘streaks’ of being right and longer ‘streaks’ than those whose ‘batting average’ is much lower. Thus, there are some analysts and commentators we should review more than others even though we know that they will be wrong a fair percentage of the time.

A third relevant factor is that individuals, according to the research that Mauboussin cites, do not always act in a completely rational way. For example, they may weigh possible losses more heavily than gains in their decision making. However, even though individual participants in the market may not be completely rational, if these participants generally act independently of one another, markets will ‘tend’ to be priced appropriately. This is because that, when aggregated into the whole market, the deficiencies of the individual decision makers seem to cancel out and the resulting prices tend to be a relatively adequate reflection of all the information that is available to the market at that time.

The time when this will not be true is when individuals do not behave independently of one another. At these times, the market becomes unbalanced because opinion tends to congregate on the buy side of the market or on the sell side and people act more like a ‘herd’ than independent individual decision makers. These are the times when the markets become ‘disorderly’ and present the greatest problem to policy makers. We have given special names to some of these disorderly situations such as ‘liquidity crisis’ or ‘credit crisis’ or ‘market collapse’.

There are two other books on markets and uncertainty that provide a good deal of insight into the world of decision making under uncertainty. Both of the books are by Nassim Nicholas Taleb: the first of these is titled “Fooled by Randomness” (Random House, 2005); and the second is “The Black Swan: The Impact of the Highly Improbable” (Random House, 2007). Both of these books contribute to our understanding of the point made by Robert Rubin that there are, at most, only a limited number of situations in life that are not subject to uncertainty. Uncertainty comes from not having all the information we need in order to make a decision or to solve a problem. The idea that we have complete information on every situation we face in life is just a fantasy. The tendency to narrow the range of possible outcomes we consider in any specific case is related to our desire for greater certainty in life: humans tend to act as if they had complete information. Taleb presents us with example after example of the absence of complete information in our decision making or problem solving.

One additional fact is emphasized by both Mauboussin and Taleb: the probability distributions that apply to most uncertain market situations are not normal distributions. Although the probability distributions used should all conform to the general rules of probability theory, it has been shown that the tails of these probability distributions are ‘fatter’ than those of a normal distribution. That is, extreme events should have more probability assigned to them than would be the case if the probability distributions were normally constructed. Thus, these extreme events may not be very probable, but the expected impact of their occurring can be more substantial than might be thought. This conclusion is not meant to frighten, but only to serve as one more piece of information that will help us to understand the performance of the markets in which we operate.

Recently in a talk, Federal Reserve Governor Fred Mishkin indicated how uncertainty can impact price relationships within a market. The case that Mishkin discussed related to the calculation of inflationary expectations measured by the difference between the yield on the10-year Treasury bond and the yield on the 10-year inflation protected Treasury securities, TIPS. This differential has been increasing since the first of the year and the general interpretation given the increase is that financial market participants now expect more inflation over the next 10 years than they had expected last fall. Mishkin argued that the increase in this differential was not due to an increase in inflationary expectations but was due to an increase in the ‘uncertainty’ of what inflation will be. In this respect, uncertainty can affect markets. But, we must deal with uncertainty as analytically as possible, for that is the best way to make decisions because it tempers the impact of the more dramatic events that we generally see in the headlines.

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