IWMC 2020: Radical Uncertainty – Rethinking our Approach to Risk and Uncertainty by Sir John Kay

Speaker – Sir John Kay, Economist and Author

Moderator – Ravi Gautham, CFA, Senior Vice President, Northern Trust Company

Contributed by – Litesh Gada, CFA, Member, Professional Learning Committee – CFA Society India

 

Considering the current scenario of uncertainty, there couldn’t have been a more topical discussion than about the Radical uncertainty by Sir John Kay at 5th India Wealth Management Conference 2020 

Sir John Kay has written several books and his latest book Radical uncertainty – Decision-making for an Unknowable Future (co-authored with Mervyn king (Ex-Governor of Bank of England)) was the one which got discussed in the session.

The timing of the book is excellent as we are going through one of the most uncertain times due to Covid 19, in past 100 years. The central argument of the book is that the economics profession has become dominated by an approach which requires probabilistic thinking to a great detail. This approach at times gives a false sense of understanding to make predictions.

In 1921, two books were published – Risk, uncertainty and profits by Frank Knight and Treatise on Probability by John Maynard Keynes. Both Knight and Keynes made a distinction between risk (which could be expressed quantifiably and probabilistically) and uncertainty (which could be not).

Knight used the title for his book Risk, uncertainty and profits because his essential argument was that it was radical uncertainty that created opportunities for entrepreneurs to make profit. However, for Keynes uncertainty is central to his understanding of macroeconomics. It is because of radical uncertainty that the competitive market equilibrium, which the classic economists have described could not be reached.

Frank Knight drew a sharp distinction between risk, as referring to events subject to a known or knowable probability distribution and uncertainty, as referring to events for which it was not possible to specify numerical probabilities.

For normal people risk is considered as something bad which needs to managed. eg: loss of capital is a risk which needs to be managed. If you mean that your risk is different from the risk of the other market participants means there is an opportunity to make some kind of profits. The fact that one has longer time horizons for investment than other people means one has a different risk and can take up different investment opportunities than other people have. There is no ways a market equilibrium can be attached a single point risk.

Reference narrative will be completely derailed by some event which people don’t expect but which might happen in some form of radical uncertainty. Risk is personal as the underlying narrative is different for each individual which has very large implications for financial markets.

We trade risks because we believe that one can handle risk better than the other person or when one person knows more about the risk better than the other. People should avoid taking on such risks. One should not get into bets where it is possible that the other person knows more than you do.  

The view of Knight and Keynes on uncertainty was later challenged by Frank Ramsey and group of American economists. They extended the framework of rational choice, which was dominant in micro economic thinking, and referred to it as choice under uncertainty. They framed an analysis of uncertainty in terms of probabilities which was subject to the axioms of rational choice. This was brought forward in 1952 at transatlantic symposium to discuss risk and uncertainty. This symposium was followed by a dinner party attended by eminent economists. The foundations of behavioural economics and behavioural finance were laid at this dinner party.

The participants at the dinner were presented with a variety of choices under uncertainty and were shown that the choices they made were not in alignment with the framework of rational choice under uncertainty. Hence, these choices cannot be assessed under framework of rationality.

This led to the beginning of behavioural economics. The premise of behavioural economics and finance was that, people ought to behave as per the rationality assumptions which underpin the models. If they do not behave, behavioural finance would refer to those behaviours as irrational.

The author believes Behavioural economics started as a critique of rationality but over a period it has become a critique of people. If we are subject to all these biases, how is it that we are so successful, how is it that we haven’t learnt to overcome these issues. Answer to this is that most of these things are biases only in relation to a particular concept of rationality.

We may treat people as if they assigned numerical probabilities to every conceivable event. This assumption of rationality is the basis of modern finance.This very idea of rationality is being challenged by the author which is as follows:

What does author mean by ‘Radical uncertainty’ and why does he want to restore the distinction between risk and uncertainty :

  • Radical uncertainty does not mean a black swan (an event to which you can’t attach a probability because you simply cannot conceive the idea of that event)
  • Radical uncertainty arises where we know something about the future but not enough
  • This is a world in which we know something but not enough. This is the world in which we are currently living and qualifies as world of radical uncertainty
  • It was emphasised and which has been covered in the book as well, that we must expect to experience a pandemic caused by a virus which does not yet exist

There are a lot of things about this pandemic that teaches us about uncertainty:

  • Pandemic itself is a striking example of radical uncertainty
  • We learn how to manage radical uncertainty
  • Managing radical uncertainty is about creating strategies that are robust and resilient to events which you cannot anticipate. It is all about preparing yourself about the world where you do not have enough information and you can still manage handle the situation
  • We also learnt ways in which people should and should not use models
  • There can be lot of events which cannot be modelled but which needs to be handled should they occur

The author is of the view that one should manage risk, try & secure your reference narrative and if one can do that, then one can embrace uncertainty. It is uncertainty that makes life interesting and rewarding both in financial and much broader sense. Uncertainty properly managed can be a positive aspect of our lives, our businesses and finances. New and unexpected experiences add spice to life. So “manage risk, embrace uncertainty”.



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