Wednesday, August 15, 2007

Misleading hindsight

In case you've just spent the past few weeks on a desert island (or a very exotic one), you would have missed one of the most panic-driven sell-offs in financial markets in years, if not decades.

One unfortunate aspect of the latest rout is that most experts don't seem to know how much further markets are likely to fall.

This puts not just experts, but people who rely on experts (e.g. investors), in an extremely awkward situation. Without any conviction on which way to trade, markets can at best go sideways or at worst come crashing down.

In reality, we're simpy in the midst of something the world has witnessed ever since the dawn of time: an extremely rare and unexpected event with an uncertain outcome.

While we usually get to hear about why a major event such as this occured after it occured, we now have the rare opportunity to witness how truly limited our understanding of uncertainty in financial markets has remained despite all of the advances in mathematical modelling and trading strategies.


There's nothing new about a lurch downwards in markets, otherwise known as "corrections". They usually occur as the result of a market being "overbought", which then leads to an inevitable decline (usually around 10%) and a subsequent "bounce".

At the moment, the exact cause of the downturn is not fully understood, so making a prediction about when and how much of a bounce is likely, is more uncertain than usual.

One explanation doing the rounds is that market participants have failed to learn that they fail to learn, otherwise known as a "black swan" event. This describes how after something completely unexpected happens, we come up with an explanation that attempts to explain exactly what happened and why it was predictable after all, thus creating a false sense of certainty about future uncertainty.

This problem is compounded by people attempting to draw analogies with past events to try and guage how much worse it might get. This effectively uses a backward-looking explanation of the past to help predict what might happen in the future!

If you were to suggest, based on your experiences at the time, that the current episode is similar to the events of October 1987, most people who work in the financial industry would have to take you at your word, since they are unlikely to have been working (alive??) at the time!

The more recent the period with which you make the comparison the more people you are likely to convince. In the end, there is a story to satisfy everyone. However, every story will have one thing in common: a misleading reference to the past in an attempt the predict the future.


We are at one of those rare times when an expert will tell you exactly what they have always known about the future: very little.

At the end of the day all you can know is what you know. While it may not always be possible to know why something is happening, it is possible to guage the ability of the global economy to weather the storms that come along.

At the moment markets are falling while the global economy is resilient. If the environment were less bouyant than at present then the current turbulence in financial markets would have much wider ramifications than they currently do.

In the meantime all we can do is sit tight and hope for the best!

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