Behavioral finance FAQ / Glossary (Uncertainty)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Uncertainty (vs. risk).




00/5i,9i,10i - 01/3i,4i - 02/4i,10i
- 03/1d - 03/2i,4i,10i
- 05/8i
-08/5i  + see risk, ambiguity,
non stationarity, probability,
uncertainty aversion, Bayesian,
dynamical system

Fog is usually all over the place
don't expect certainty.

Definition (general):

Uncertainty refers to a situation in which there is no way to get exact

and reliable information and to make a safe prediction.

This kind of fog can be found in various physical and biological fields
and even more in human and social ones
such as economics and finance.

In this World, the future, and even the current realities,
are far from being fully known. We have to face the unknown.

We are deeply immerged in dynamical systems (see that word),
human life is a typical one, society also.

Most are by nature neither fully stable nor fully predictable,
whatever the statistical data and probability laws (even if we
should not neglect them as a first approach in run of the mill
situations).

Definition ( economy, finance):

In its economic and financial sense,
an uncertainty (*)
is a risk (**) that is not measurable

Neither its size (possible amount of loss) nor its probability (frequency
of occurrences) can be quantified.

In such cases, past data are unavailable or irrelevant.

(*) also called ambiguity.
(**) or opportunity, but the word refers mostly to possible problems

        or damages.

Differences and convergences
     between risk and uncertainty

Improbable probabilities?

A risk (see that word) is a damaging event that might

occur in the future and is supposed to be measurable,
or at least rather precisely estimated

* in its frequency

* in the size of the loss it could bring.

The techniques which are used rely mostly on historical
probabilities, polls
or theoretical stochastic calculations.

Uncertainty refers obviously to future - favorable or not -
    events
which possibility is not / cannot be objectively
    quantified
.

This relates to events and situations which are

* either completely new, unprecedented (disruption from
   the past),

* or rare, infrequent ("black swans"),

* or at least unexpected (surprises).

Here, there are no, or too few, historical
references
.

Or when they are available, they are hardly relevant to the
new case. They do not give clues that would lead to identify
"laws" or patterns that drive the system behavior and to make
at least a roughly quantified estimate of risk.

No wonder that this lack of reliable information can
freeze or distort rational reasoning to some extent
and foster emotions such as fear.

Uncertainty applies to many
     important life situations

Unknown territory behind the door.


Uncertainty / ambiguity is found in dynamical
and occasionally "chaotic" systems
.

Our World itself is such a dynamical system (see that phrase).

To believe in a stable and predictable world, which would
oscillates under the breeze of well known random laws,
is largely illusory.

Of course, some minor or routine phenomena can be dealt
this way (it is essential not to neglect such laws as a first
approach, but at your own risk).

Whatever guesses we try to do, the future will bring
surprises.

To accept and enjoy life is to accept adventure and surprises
(uncertainty tolerance).

Only death is stable and certain, so better not wish for this
kind of "stability" ;-)

Social and economic evolutions belong obviously
to such types of dynamical systems.

Not only the physical environment creates hazards - but also human
reactions
, decisions and behaviors -are far from being fully predictable.


In times of upheaval that the world experiences often
(like 
nowadays) historical references are poor predictors.

Uncertainty in financial markets

Money as a pet is not fully tame.


In stock markets, like in many other human activities, the future has
always elements of uncertainty.

Various phenomena contribute to what is called the market's
"structural uncertainty"
.

As examples, here are two important factors:

1) As said about risk, it is dangerous to expect too
    much from 
stochastic

measurements (*) ofmarket risk, made on past
series,

(*) Stochastic calculations (see that word) apply to "dynamical
      probabilities"
of events which occurrences are supposed

to match a random law.

Evolutions might stray from full randomness.

Thus stochastic calculation cannot fully help predict the
future market behavior (see "numeracy bias" and law of "small
numbers").

For example:

Statistics on past volatility do not tell if future fluctuations will
    be similar, larger or smaller.

The "price of risk", calculated from the current prices of

financial  instruments used to transfer risk - see (implied)
volatility - is not  fully reliable either.

The credit derivatives prices just before the subprime crisis
underestimated the perils.


2) Also, market information at the same

time is overabundant (see cognitive overload) and has
pockets of ignorance.

This is due, here also, to the growing complexity the world
of banking and finance, as a typical dynamical complex
system
.

To take again the subprime lending securitization system
as an example, what was lacking,when it burst, was a clear
map of which institutions carried the most risks.

How to handle uncertainty? 


Even so, in case of uncertainty, we can find helpful for decision making:

To build many scenarios of potential good or bad events, however hard
   it is to estimate their probabilities.

To use adjustable subjective probabilities
  
degrees
of beliefs, temporary opinions and
   assumptions).

Their adjustment can be made gradually, when new information and
events are known by using Bayesian (see that word) inferences, as
well as fuzzy logic tools.

Uncertainty aversion (vs. risk aversion) / avoidance / premium

See uncertainty, ambiguity,
wishful thinking,
subjective
probability

Fear of the dark, as a source of legends.

As uncertainty is unavoidable, better develop uncertainty tolerance and
admit that our decisions are bets on the future without having all the
elements.

People, and among them investors, are usually more
"uncertainty / ambiguity averse" than "risk averse"

(see the definition of risk, as an uncertainty that is measurable or seen as
such).

Risk, based on verifiable information, is prone to rational reasoning.

On the other hand, ambiguity is poor in reliable information that
might be processed by rational cognition and provide guidance
on how to behave.

Because of that lack of reliable external food for thought,

     ambiguity activates some brain areas prone to emotions
     (mostly
fear )

So what happens?

This difficulty to assess uncertain situation to help make decisions,
and the fact that people usually do not like such uncertainty
make understand why:

They might react emotionally towards such uncertainty.


Or they might just try to resist changes (see below)

even if that resistance, far from avoiding uncertainty, make them
unable to adapt to it.


Or they might prefer to hear (or build) any story

that seems to explain what happens.

You don't know what it is? Make as if you know!

Belief and pseudo certainty avoid the pain of ambiguity

...often at the price of causing wrong moves.

Molière, a classical French playwright, has shown how
a doctor gives fancy scientific name to the imaginary
illness of a patron who cannot stand the unknown and
finds comfort when such phony labeling and "cures"
are given.

In the same way, people might reassure themselves by trusting
probabilities of future outcomes that are born from their own
invention.

Uncertainty aversion
    and resistance to changes

Fear of jumping into the unknown.
Being afraid of ...what we don't know what to be
afraid of.


As an example of uncertainty aversion, people often resist changes
(see status quo bias).

They can even prefer to stay in a well known bad situation and
to freeze or reject adaptations moves if their results
cannot be fully estimated.

One reason is that when trying to do something, unknown
   
negative effect might arise

That is to confuse the need to analyze things (see below)
and
take precautions with an inclination towards passivity
/ conservatism.

A parallel one is that serious efforts of analysis and

adaptation will be needed when facing change. "Is it
worth the trouble?" is the question, which of course
can have its rationale.

But obviously, an emotional "commitment" in past
    behaviors plays a part in such a bias.

Uncertainty aversion and finance

The more ambiguous, the cheaper

In financial matters, when visibility about the
future is foggy, probabilities, the usual parameters to measure risks, lose
their meaning or become purely subjective.

Investors might change their valuation of those odds with any small piece
of news
they can grab, whatever its relevancy.

In such cases when investors get conscious of the very limited visibility of
what could happen, the price and return volatility of the related
assets gets much higher than in normal times.

This leads investors to demand for those assets an
uncertainty premium or ambiguity premium

that is much higher than a normal-time risk premium.

To sum it up, in highly uncertain situations, asset prices move
     a lot, but are generally cheap.

To deny market uncertainty can bring bad surprises

The peril of creating false certainties.

Sometimes, people are trusting apparent probabilities
too much, or even create their own illusive mental
certainties.

Uncertainty is then hidden, overlooked or even denied:

Either because short-time statistics give the illusion that

probabilities are well known (see numeracy, small numbers).

Or because investors build irrational certainties:

see pseudo-certainty, wishful thinking, magical thinking,
belief, hope...

As they hate uncertainty, they feel better to believe in
anything, be it a mirage or fantasy.

Hope is a powerful help in going on living, but it makes a
flurry of uncertainty / mystery / magic seekers or, in other
words, "wishful thinkers" emerge.

The bulk of investors might become overly confident and
"uncertainty tolerant".

Some market bubbles are built on such illusory prospects.

They often end in large price corrections when reality (the unexpected
events) strikes.

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