August 1, 2019

Rethinking Investment Risk: Why We Need To Go Beyond 'Volatility'

“Economists have been happy to adopt the assumption that in a world of radical uncertainty, people optimize by maximizing expected utility, and that the resulting ‘small world’ models have direct application to policies in the real world.”

“Risk-averse people are reluctant to move outside their comfort zone…..they seek certainty in a world of radical uncertainty by trying to limit themselves to a stationary ‘small world’ framework.”

“Risk in a world of radical uncertainty is the failure of a projected narrative, derived from realistic expectations, to unfold as envisaged.”


A Radical Conversation

I was lucky to sit beside John Kay at the recent May meeting of the CFA Institute’s ‘Future of Finance’ Advisory Council. His reputation as one of the world’s deep thinkers on finance and investment matters is well-earned. John spoke about a book titled “Radical Uncertainty” he is co-authoring with another recognized deep thinker, former Bank of England Governor Mervyn King. As he described the essence of the book’s messages, they sounded very similar to my own as set out, for example, in last September’s Letter titled “Short-Term vs. Long-Term Investment Risk: Really Understanding the Difference”.

On that Letter, John commented “Mervyn and I come to the same conclusions in a more iconoclastic style”. I asked John if he could share drafts of some of the book chapters already written. Graciously, he sent me three. The quotes above come from those chapters, indeed written in a more iconoclastic style than I use in my Letters. The Kay-King (K-K) message is clear: by using the ‘small world’ models of portfolio theory, return volatility, the efficient markets hypothesis, and utility maximization, asset owners (as well as their advisors and even regulators) effectively side-step addressing the longer-term investment reality of what they call ‘radical uncertainty’. Arguably, in doing so, asset owners are failing to live up to the fiduciary duties they owe asset beneficiaries.

This Letter explores the asset owner implications of investing in a world of radical uncertainty.         

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