Thursday, February 18, 2016

Think Another Crash Is "Impossible"? Think Again

The confidence that risk can be quantified and mitigated is misplaced.
If there are limits on what we can know of the future--and clearly there are--this sets limits on our ability to quantify and mitigate risk. Longtime correspondent Lew G. submitted this thought-provoking riff on the system's intrinsic capacity for cascading decisions (for example, selling everything not nailed down) that upend our understanding of risk.
Here is Lew's commentary on risk:
There is a tradeoff of importance, detail and distance into the future, sort of a Heisenberg's uncertainty principle. The cost of certainty and detail at any future time goes up as the economic importance goes up because so many more people are trying to understand and control that small part of the future. This introduces more variables and more uncertainty because many of those variables will be linked in unknown ways. (emphasis added by CHS)
Estimating risk is inherently a matter of dealing with those links. The number of paths through a net which must be evaluated to determine risk is exponential, as cascades can start from anywhere and rapidly take down connected nodes in the network.
One would expect that a bank's internal risk analysis programs will try to do some of this, but they can only know the bank's point of view, not the exposure of any other financial nodes in the network, or the fantasy level of their accounting.
Because everyone is super-optimistic in a boom, crashes are inevitable, and the size of the crash is proportional to the fuzz/misinformation in information flows, e.g. mark-to-fantasy entries in banks' assets, details of all the outstanding derivatives, swaps and contracts, etc.
Thank you, Lew, for describing the complex nature of risk. There are a number of ways to uncrate the dynamics of risk addressed here, and I'd like to address two specific instances.
1. Lew conjectures a risk-equivalent of Heisenberg's uncertainty principle, which holds that the more precisely the position of a particle is determined, the less precisely its momentum can be known, and vice versa.
In a financial setting, a great many analysts and programs are seeking precise forecasts on GDP, capital flows, future profits and revenues, valuations and so on--all the components needed to forecast the likely range of outcomes.
This information is needed to properly hedge risk, and to profit from markets moving in the anticipated direction.
But if Lew is right about a Heisenberg analog in finance, this suggests the greater the certainty in the forecast, the less precisely the risks can be accurately estimated.
This limitation in our knowledge of the future helps us understand why "impossible" cascades of selling and the implosion of "safe" assets occur with regularity, despite the widespread use of sophisticated risk-management tools.
(Given the concentration of talent seeking certainty in a narrow slice of financial data, the potential for group-think, both in humans and in the software written by humans, is another potential source of risk.)
2. If the linkages between variables and nodes are incompletely known or understood, disruptive cascades can arise in areas thought to be low-risk. As the cascade spreads through the network, it starts taking out nodes that participants suddenly discover are connected in unexpected ways to other nodes that were considered only lightly connected to risky nodes.
In a Heisenberg analog network, risk can never be nailed down with any certainty. The confidence that risk can be quantified and mitigated is misplaced. A system riddled with various forms of misinformation and links that are not apparent until the cascade has begun is intrinsically prone to crashes that take down every node in the network.
This is not "impossible;" it is an excellent description of what happened in 2008-09.

NOTE: Contributions/subscriptions are acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.
Thank you, Dennis G. ($20), for your most generous contribution to this site -- I am greatly honored by your steadfast support and readership.
Thank you, Wendell D. ($20), for your most generous contribution to this site -- I am greatly honored by your steadfast support and readership.

Terms of Service

All content on this blog is provided by Trewe LLC for informational purposes only. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site. The owner will not be liable for any errors or omissions in this information nor for the availability of this information. The owner will not be liable for any losses, injuries, or damages from the display or use of this information. These terms and conditions of use are subject to change at anytime and without notice.


Our Privacy Policy:


Correspondents' email is strictly confidential. This site does not collect digital data from visitors or distribute cookies. Advertisements served by a third-party advertising network (Investing Channel) may use cookies or collect information from visitors for the purpose of Interest-Based Advertising; if you wish to opt out of Interest-Based Advertising, please go to Opt out of interest-based advertising (The Network Advertising Initiative). If you have other privacy concerns relating to advertisements, please contact advertisers directly. Websites and blog links on the site's blog roll are posted at my discretion.


PRIVACY NOTICE FOR EEA INDIVIDUALS


This section covers disclosures on the General Data Protection Regulation (GDPR) for users residing within EEA only. GDPR replaces the existing Directive 95/46/ec, and aims at harmonizing data protection laws in the EU that are fit for purpose in the digital age. The primary objective of the GDPR is to give citizens back control of their personal data. Please follow the link below to access InvestingChannel’s General Data Protection Notice. https://stg.media.investingchannel.com/gdpr-notice/


Notice of Compliance with The California Consumer Protection Act
This site does not collect digital data from visitors or distribute cookies. Advertisements served by a third-party advertising network (Investing Channel) may use cookies or collect information from visitors for the purpose of Interest-Based Advertising. If you do not want any personal information that may be collected by third-party advertising to be sold, please follow the instructions on this page: Limit the Use of My Sensitive Personal Information.


Regarding Cookies:


This site does not collect digital data from visitors or distribute cookies. Advertisements served by third-party advertising networks such as Investing Channel may use cookies or collect information from visitors for the purpose of Interest-Based Advertising; if you wish to opt out of Interest-Based Advertising, please go to Opt out of interest-based advertising (The Network Advertising Initiative) If you have other privacy concerns relating to advertisements, please contact advertisers directly.


Our Commission Policy:

As an Amazon Associate I earn from qualifying purchases. I also earn a commission on purchases of precious metals via BullionVault. I receive no fees or compensation for any other non-advertising links or content posted on my site.

  © Blogger templates Newspaper III by Ourblogtemplates.com 2008

Back to TOP