There’s a fundamental misconception in the finance industry that has led many smart people to make some very bad decisions.
In college, finance majors are taught to calculate the risk of a financial asset based on its price variance, which is essentially “how much its price fluctuated in the past”.
If the price of an asset did not fluctuate too much in the past, it would be treated as a low risk asset, and vice versa if its price fluctuated a lot.
Right away, even the layman can see what’s wrong with this approach. Just because the price of a stock was stable in the past, doesn’t mean that it will be stable in the future.
As long as we can’t see the future, there’s no way to know exactly how risky a financial asset is.
But alas, investment professionals have overlooked this simple fact and decided that investment risk can be calculated in the same way one calculates the odds of rolling dice.
What they forget, is that while all possible outcomes of rolling dice are known in advance, the future isn’t.
This “oversight” results in a situation where people invest their money on the assumption that all possible risks have been accounted for.
Of course, by the time they find out that this is a faulty assumption, it would be too late.
From 2001 – 2005, as US housing prices were rising at an alarming rate, the finance industry flourished on profits made from the fees they charged. So one wouldn’t be surprised to see them promoting the fantasy of ever-rising house prices. There was, after all, a strong financial incentive to do so.
But it wasn’t just the banks and mortgage houses that sold this narrative.
Consider that even the then-chairman of the Federal Reserve denied the possibility of the future being different from the past.
INTERVIEWER: Tell me, what is the worst-case scenario? Sir, we have so many economists coming on our air and saying, “This is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.” Some say it could even cause a recession at some point. What is the worst-case scenario, if in fact we were to see prices come down substantially across the country?
BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.
Bernanke, like most economics and finance majors, was taught the same theory in school: current risk can measured based on historical risk.
Of course, by the end of 2008, this theory was proven to be wrong.
Uncertainty is not Risk
This highlights the big difference between risk and uncertainty.
The latter can be calculated (based on all historically known outcomes), while the former can’t.
When you play blackjack, you are taking a risk because you can calculate the odds of winning based on the cards left in the deck. This allows you to optimize your decisions to give you the best chance of winning.
Unfortunately, many traders assume that this is what trading is like. They spend their time working out their winning percentage and risk-reward ratio, in an attempt to optimize their trading performance.
They think, “If I just extend my profit target by X pips, my returns can go up by Y percent!”
What they’ve assumed however, is that the market will stay the same.
But guess what? It won’t.
Inefficiency isn’t always bad
In a situation of risk, it pays to optimize performance. When you know the exact odds of having a winning poker hand, you can (and should) adjust your bet size accordingly.
In situations of uncertainty however, it pays to do the opposite – increase slack in the system. When you don’t know what the future holds, the smart thing to do is to be prepared for the worst.
The thing is, however, having slack in a system makes it look inefficient.
For instance, to reduce the impact of a stock market crash on my investment portfolio, I might leave just a small portion of my savings in stocks, while keeping the rest in cash. To an outside observer, my lower overall returns would be viewed as inferior compared to someone who puts all his money into the stock market.
Now what the observer doesn’t see, is that in the event of a market decline, I would perform much better than the other guy.
But of course, people get much more excited about what they can see, than what they can’t. No one celebrates the prudent investors until disaster hits.
The bottom line is that in an uncertain environment (such as in trading), you have to carefully balance between optimizing performance, and preparing for the unexpected.
Traders tend to think too much about the former, and not enough about the latter.