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Monday, 26 July 2010

Capricious Markets

The market is capricious.  We are paraphrasing a line from one of Bernard Cornwell’s series of historic novels on 9th century England, where he referred to the ‘old gods’ (pagan gods) of the Danes and Vikings as capricious.

So if the impulsive nature of markets is to be appreciated for what they are, then why are we trying so hard to manage risk completely out of existence? 

We will focus on two specific factors today in what we refer to as the ‘dumbing down of risk’.

A strict or narrow definition (old financial language) of risk is possibly that it is a quantifiable number with a probability ranking and we can therefore attach a statistical inference to the occurrence of the risk event.

Yet in The Health & Safety Executives language a risk and “Risk management involves you, the employer, looking at the risks that arise in the workplace and then putting sensible health and safety measures in place to control them”.  So in the common language in the work place the HSE has managed to destroy the proper use of the work risk and risk management with this dumbed-down version.

In our mind, if the risk cannot be quantified and expresses on a scale of probabilities, then it is not a risk, but an uncertainty.  And we can manage both risks and uncertainties, but the emphasis is different.

Maybe any situation or health and safety ‘risk’ can eventually be codified on a risk probability matrix, but the cost involved in getting to this situation is prohibitive, so we shall stick to our guns and call a health and safety issue a ‘Health & Safety Uncertainty’.

Let’s recap briefly the difference between what risk is (supposed to be) and what uncertainty is:
Risk in investment and market participation is the likelihood of a quantifiable measurable outcome either occurring or not occurring.

Frank Knight In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the distinction between risk and uncertainty.
… Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. … The essential fact is that “risk” means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. … It will appear that a measurable uncertainty, or “risk” proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We … accordingly restrict the term “uncertainty” to cases of the non-quantitive type.”
Too summarise therefore, risk should be a measurable and quantifiable occurrence, whereas uncertainty is what the HSE addresses, but misinforms as risk, namely the likelihood of something occurring, but that likelihood is not quantifiable.

So where does this detour into the use of language leave us as far as the Capricious Market is concerned?

We suppose that because market participants are both humans and mechanical systems (eg. ETS – Electronic Trading Systems), one of these participant groups, namely the humans have a level of sophistication and complexity (irrationality) that leaves the best construed risk models in tatters, once the uncertainty element of human emotion and the perception factor unleashed.

Therefore, to construct models of rational behaviours, the outcome and predictability of non-human mechanical systems (in other words more models) should be able to predict the behaviours of other models.  But to extend this to human actors clearly moves us more firmly into the domain of uncertainty and not risk.

Therefore, we conclude that the markets will always be capricious as long as irrational beings are willing and able participants.  Until this ceases to be, let us ensure that we get the use of our risks sorted out from our uncertainties.

theMarketSoul ©2010

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