Risk vs. Uncertainty

Economists distinguish between risk and uncertainty. the former can be priced by financial markets while the latter cannot. The distinction between the two was made by Frank H. Knight in his seminal book: Risk, Uncertainty and Profit. In brief, risk is present when future events occur with measurable probability and uncertainty is present when the likelihood of future events is incalculable

Economists distinguish between risk and uncertainty. the former can be priced by financial markets while the latter cannot. The distinction between the two was made by Frank H. Knight in his seminal book: Risk, Uncertainty and Profit. In brief, risk is present when future events occur with measurable probability and uncertainty is present when the likelihood of future events is incalculable

This distinction between risk and uncertainty is a very useful tool for helping to understand market turmoil. Risk can be measured and can be priced in because market participants have experience of similar events. For example, we know the likely distributions of price spike sizes for non-farm payroll economic releases, so the market adjusts accordingly.

However, uncertainty cannot be priced by markets because it relates to events that the market has no experience and tends to create “fat tail” style price distributions. For example, no investors had any experience in 2007 as to what the subprime mortgage market risk actually was, or how CDOs would perform when they started failing. As a result the market started to plunge rapidly when the first round of banks announced they were in trouble. Fortunately, optimistic views about the global economy prevented the fall in the market going any deeper and the market recovered as buying opportunities started to appear. If this was coupled with a very pessimistic view of the global economy, it could have easily resulted in a crash.

Black Swans
Nicholas Taleb in his book on “Fooled by Randomness” referred to major uncertainty events as black swans. The term black swan comes from the 17th century conception that all swans were white. In that context, a black swan was a metaphor for something that could not exist. The 17th Century discovery of black swans in Western Australia metamorphosed the term to connote that the perceived impossibility actually came to pass. David Hume used black swans to demonstrate falsification:

“No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion” – David Hume

Black swan events are significant uncertainty events. An example of a black swan is the Russian credit crisis which too down Long Term Capital Management (LTCM) in the late nineties. LTCM were using artbitrage to trade long dated government bonds. During the Russian Credit crisis they didn’t close down their system and dug themselves deeper and deeper believing the market would eventually right itself. The ended up digging themselves in so deep that it took the US Government to bail them out.

Nerves of Steel
“Markets can remain irrational longer than you can remain solvent” – John Maynard Keynes

Many fund managers and traders use a method where they build up positions using a combination of value investing, dollar cost averaging and wide stops:

Value Investing: Value investing is an investment technique that derives from the ideas on speculation that Graham & Dodd defined in 1934. It generally involves buying instruments whose price appear under-priced by some form of fundamental analysis.
Dollar cost averaging: Dollar cost averaging is a technique which is intended to reduce exposure to risk associated with making a single large purchase. The idea is simple: spend a fixed dollar amount at regular intervals on a particular portfolio, regardless of the price. In this way, more positions are purchased when prices are low and fewer shares are bought when prices are high. The premise of dollar cost averaging is that the investor wants to guard against the market losing value shortly after making his investment. Therefore, he chooses to spread his investment over a number of periods.
Wide Stops: The theory behind wide stops is the market can be quite noisy and investments can depart a reasonable distance from their underlying value by a fair margin. Therefore to avoid being stopped out the trader should use very wide stops.
Fund managers and traders who trade these kind of methods do well when the market is acting according to its fundamentals, but when uncertainty or a black swan arises their accounts go into deep drawdown. If their pockets are not very deep or they personally can’t handle the pressure of a large drawdown, they will close their trades and wipe out a large chunk of their trading accounts.

Macrotactics is a blog devoted to recording a part time trader's journey into the world of trading currencies. In my day job I work as a manager in an Information Technology company. I live in sunny Queensland, Australia with my wife, a cat and a baby on the way. I have been banging my head on this trading thing for at least 3 years now and the deeper I dig into the topic of trading, the more I realise there is to learn. Trading for me has become... More