April 2012 - Richard 'Jerry' Haworth: Volatility “Urns” Respect

Volatility is a combination of, amongst other things, uncertainty and risk. Uncertainty is the “unquantifiable” risk and “normal” risk is the “quantifiable” risk.

How do we know what mixture of quantifiable and unquantifiable risk we are facing?

If a “city-slicker” tried to walk through the Serengeti Plains in Africa, we would assume they face a lot of uncertainty vis-à-vis normal risk. An Olympian competing in an event or a poker pro playing in a world poker tournament faces little uncertainty but a lot of known risk i.e. the odds of being successful can be easily quantified.

In finance it is a bit more difficult. There is very little indication of upcoming uncertainty and we have to rely on anecdotes like “the shoeshine boy who was giving stock tips indicating a toppish market”. In fact whilst the “normal” risk of being in the market is fairly well known and can be approximated by the standard deviation, the uncertainty is counter-intuitive and NOT normally fully reflected in the standard deviation which in turn is our proxy for total risk.

What does this mean?

It means that when we forecast volatility we are normally wrong. We are complacent and undervalue the role of uncertainty in good times and OVERVALUE it after bad times.

When an event like 2008 happens, our biases can lead us to make potentially incorrect investment decisions POST the event?

At a recent volatility conference we hosted in London an outstanding maths PHD provided an excellent explanation of this phenomenon via the “urn” analogy. She asked the audience “if there were 100 balls in an urn, 50 red and 50 black and I will pay you $100 if you guess the correct ball colour of the first ball drawn. How much will you pay to play the game?” The answer is “anything up to $50” as there is a 50/50 chance. She then modified the game saying “if I didn’t tell you what the composition of the colours of the balls in the urn are, how much are you willing to pay to play the game?” The best reply she could get from a conference of finance professionals was “$10”. $10!!!!!!!!!! Implying a 10% chance!!! (The first ball odds seem to still be 50%, even if there were 100 black balls there is a 50% chance we would choose black.) Then it struck me how radically we change our investment outlook post a Black Swan event. Investors implicitly overvalue uncertainty post a systemic event in which uncertainty appears unannounced.

The consequences are vast. Investors are unwilling to invest more than a marginally small amount in a market which is PERCEIVED to be full of uncertainty. This uncertainty dissolves over time hence the markets “climb a wall of worry”. In the meantime, they miss a potentially rewarding low risk/high return environment because they mis-calculate “total” risk.

The bottom line is the chances are that the risk you perceive in the market may not be the risk you are actually facing.

“The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.”

Warren Buffet