Jason Jiang's  Instablog

Jason Jiang
Send Message
  • Adapting Uncertainty 0 comments
    Jul 18, 2013 11:31 AM

    Isn't it obvious that we live in an uncertain world? I guess it is. However, human behavior often indicates that we don't really appreciate this fact. If history is of any guild, it will take perhaps hundreds, if not thousands of years for us to evolve psychologically or sociologically to adapt to the uncertain aspects of modern life that has come to light thanks to the past few hundred years of rapid progress of civilization. If that time frame holds true, with the power we already have in shaping the environment, we stand a good chance to have destroyed the civilization way before learning to adapt to it. That is an open question/concern about a pretty much uncertain future. So let's not worry about it for now.

    One does not need to understand quantum physics or chaotic mathematics to acknowledge the world as we see it is intrinsic uncertain. Though, as our knowledge increases, the level of uncertainty decreases, we should be humble enough to admit that our knowledge is not that complete, that there is more that we don't know than we do know. Further, as our knowledge base expands, our society gets more complex. It gets me to speculate that the complexity of the society would always be one step ahead of our ability to understand it. Like the legal systems, culture will also be steps behind. It is advantageous for individuals to master the art of navigating in this uncertain world.

    Altruism and farming, a bit of history:

    Altruism is widely observed in animals, and it was explained in recent decades by reciprocity, social signaling theory and in terms of genetic selfishness. Living in the modern society, we may not realize how opportunistic hunting is. Even the best hunters in the animal world fail to find suitable pray most of the times. Those who survived so far usually developed instinct to share their pray in hope to have their back scratched when luck turns against them. Reciprocity requires certain level of intelligence so those mutual benefit group recognizes its members and outsiders have relatively little chance to exploit the group. This type of Altruism is partially unconditional but mostly reciprocal. Social signaling and genetic selfishness theory are not survival strategy spring from uncertainty on the individual level, so I shall not discuss them to avoid being too scholarly.

    In early human history, spanning about a million years, in additional to sharing meat among tribe members, we developed hunter& gatherer mode. Many literatures suggest eating meat contributed greatly to evolution of larger brain size, especially front lobe. Hunter risk their life daily on such an important task, modern men would naturally assume that the society must have been male dominated. However, like for most animals, the human hunters often return home empty handed. There they arel welcomed with eatable wild plants, often provided by their socially monogamist partners. It is so frequent that the hunters fail to capture prey that the ancestral hunter& gatherer society were mostly egalitarian. In retrospect, we can say that hunter& gatherer mode was a great invention that mitigated the problem of uncertainty intrinsic to hunting, but importance of meat had to step aside to make room for the readily supply of the produce of the forest garden.

    Then, about 10,000 years ago, farming and animal domestication came along. On one hand, farming could produce more food to support larger population, on the other hand, pest and flood can ruin a whole year of hard labor. To move from hunter& gather mode to farming is to move from managing day to day risk of starving to encountering possibility of starving for a whole year, or many years (as is the case in Australia). It is not a risk individuals can manage. Consequently, it was not until government took shape, people started to move aggressively from hunter& gatherer mode to farming.

    It appears to me, since uncertainty often threatens the very survival of our ancestors, they dealt it with utmost conservatism, to the degree if something is not certain, it is not worth doing. I think this leads to our inability to think in probability terms, when most uncertainty in this modern world is no longer life threatening.

    The modern uncertain world:

    Failing to adapt to the modern uncertain world, we constantly fall prey to manipulation as individual and committing fatal mistakes as group. I shall give some examples:

    /1/Although when friends ask me about investment opportunity, I point them to bonds most times, that is only because I perceived them as not being able to think straight about uncertainty (and volatility) of productive asset. I personally believe fixed income investment is intrinsically unsound, especially for retailer investors. Bond is a promise. A credit worthy borrower likes to give promises instead of sharing a part of its future, because such a borrower can almost certainly earn more profit with the proceeds of borrowing than the interest charge. With this type of borrower as counterparty, investor's earning is minimized. When the borrower is non-credit worthy, in which case its earning is not enough to repay commitment, retailer investors who shun junk bonds do not get any upside either. In most cases, the investor receives the promised interests and repayment at maturity date, but the intermediate volatility is greater.

    The primary reason for retailer investor to get into fixed-income is that the downside is limited, despite the upside is limited too. I do know these investors are thinking downside not in terms of volatility of security quotation but of fatal consequence such as bankruptcy. That said, had hunter abandoned their spears and farmers left their land just because their works sometimes produce no yields, civilization would have stalled. That is precisely what fixed income retailer investors have experienced in the past. Their investment returns were barely keeping up with inflation. Avoiding occasional fatal events associated with equity investing requires only modest level of diversification. Simple increasing family size from one to two can prevent hunters die from hunger. Uniting as tribe reduces that risk further, much like investing in a mutual fund.

    /2/while most people do not diversify their fixed income investment, they tend to over-diversify when it comes to real life events, in some countries they overuse insurance, in other countries they abuse friendship, or they do both. Let's take on insurance.

    Insurance industry has transformed itself from the helper of the first resort to the new role of the financial massager for both individuals and institutions. The services become more for the psychological comfort than for life saving. I mean, if one cannot afford to lose something, he cannot afford to cover those risks with insurance either, unless he has a better knowledge about particular risk than insurance companies and can drive a hard bargain. An average earner could not afford to lose his house to fire, or flood, or hurricane. Heart attack, or cancer, and many other diseases can deplete all his resources. So is injury from work, or travel, to name just a few. In the end, his income could only insure him a limited number of risks. If he is lucky, he gets hit by a car early in his life so that insurance shows its benefit. It is like hitting a jackpot, except he won't be happy. If he is unlucky, after spending money for years on insurance he get hit by things not covered in the insurance policy. More often, as seen in casino and lottery, insurance company would pay him insignificant sums for minor risks that occur quite frequently. These frequent near misses keep the insured psychologically stimulated to continue buying the services.

    Insurance companies are not that bad. In fact, most of them incur underwriting loss that have to be made up by investment income. It is just that there is very few insurance products that carry the same benefit (recall, not finding prey is frequent and fatal) as sharing food in a hunter& gatherer tribe. A lot of risks under insurance coverage are minor. They may set you back financially by a year or so, and that is it. People who consistently pay money to insure that kind of risk is like financial boiling frog.

    Institutions are no exceptions. Public companies, with all those insurance and hedging operation to smooth earnings, are the worst.

    /3/ intellectually, we understand that business is endowed with uncertainty. There are so many uncontrollable factors that even insurance companies cannot cover them. But, much as in anything else, we just like to see improvement every year, or even every quarter in business. To demonstrate smooth progress, managers use every measure, whether it is insurance, hedging, over-diversification, or contract backdating, LIBOR manipulation, you name it. These measures do various degrees of harm to the profitability and integrity of the company and much of this damage are hidden from investors' view. I generally shun companies whose management talk proudly about those earning smoothing operations.( They have better names for these) A CEO who would sacrifice 1 percentage point in gross margin to demonstrate stable earning power is more likely to instill similar performance measurement scheme within the corporation. To avoid critical scrutiny by CEO, other senior managers may be sacrificing another percentage point. Then there are middle level managers and junior managers. With each level of bureaucrats subjected to irrational performance review, we lose some competitiveness throughout the company. The net result is the saying "elephant don't fly".

    Having said that, I found very few public companies could take the world as it is. And I don't expect to see much change in this respect.

    /4/the typical stock price of a main board listed company could top 20x PE and bottom 10x PE in any particular year. Such level of swing in price happens almost every year to every stock. Anyone who has watched the market closely for 10 years would find it hard to believe the market is rational, even if he himself is frequently irrational. Efficient market hypothesis says that most investors would underperform the market in the long run. That is correct. It is proven fact. But the reason is not that the market is efficient. We know valuation is about discounting cash flows, or qualitatively it is about making sense of future, which has large elements of uncertainty and lends to wild imagination in both directions. Investors seem to not understand that encouraging news today will be met with a discouraging new tomorrow, probabilistically speaking. When an uncertainty arises in front of them, what is learnt about the basic economics and the management capability/limitation is quickly forgotten. So the market is irrational because the participants are irrational about valuation. How can irrational participants achieve better investment result than irrational participants as a whole? The market does not have to be efficient to leave most investor return below average.

    /5/all previous examples are to do with people not being able to cope psychologically with minor yet uncertain setbacks. On other examples, when work is certain while benefit is uncertain, or when catastrophe is certain but remedy is uncertain, we tend to choose the convenient path, that is doing nothing. Throughout the evolution history, uncertainty is often tied to life and death scenarios, it seems that we are mentally wired to avoid thinking too much about it, we let emotions and impulses take over.

    The benefit of research is extremely uncertain. Even the best scientist (and technologist) at the latest stage of a discovery could not confidently say much about the possible benefit. Although scientists have learnt to brag about potential benefit at any stage of research after so many years of negligence by funding parties, they don't within the scientific community. While most scientific quest ends in failure, collectively science has been the main driver of modernization. So if you really think about it, to not invest aggressively in research is plain stupid. It is equivalent to treating hunters as inferior race or ruling farmers as slaves, which we human have done in the past. Obviously, individuals have patent protection concerns. But these problems are solvable if the commoners are aware how much we lose from inaction.

    The catastrophe of population bomb or climate warming is quite certain, but we have little idea on how to prevent them. Globally, my guestimate is less than 0.001% of the world resource is even remotely related to finding a cure. In this case, I could not claim that people are thinking irrationally. I guess the argument resembles the one used by smokers. "Yes, heavy smokers on average live 10 years shorter. But eventually we all die, and I would have had many years of puffing pleasure, plus I might be an exception of the 10 year rule". In the end, they will come to regret, because animal are built to survive, not to enjoy life. The enjoyment is just a side effect of survival bias, it is something that keeps us having the will to survive and reproduce.

    Causes:

    If I am asked to give a reductionist explanation for all these behaviors, I would go for "human brain is not initially built for thinking. Fight or flight has been a much better system for millions of years, and brain is just too slow for that process". Specifically, I think there are three manifestation of this:

    /1/ our language is not suitable for communication in probability space.

    /2/ instead of learning the fundamentals methodologically, we prefer mental short cuts. There you inevitably end up with astrology, day trading, creationism and all sorts of parasitic memes.

    /3/ we have relatively short memory span. So the only thing we learn from history is that we don't learn from history. Plus, short memory span determines that we live in the moment, and could not think critically about the future either.

    Epilogue:

    I kind of get a feeling that readers of this article will most likely show a glimpse of contempt as there is nothing they hadn't already known. This feeling pushed to drop my initial plan of providing detailed evidence of irrational conduct mentioned in the piece. For those who have the ability to think straight about uncertainty, I pray you act accordingly.

Back To Jason Jiang's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers
Most Commented
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.