Expect the unexpected

On a recent flight back to London, a stewardess announced that “we are expecting unexpected turbulence throughout the flight. Please keep your seatbelts on.”

While it might seem paradoxical at first, it’s clear she was saying “while we’re fairly sure there will be turbulence, we’re not sure when it will occur.” This is similar to how we perceive investment risk – we’re not sure when and where there will be volatility or falls in value, but we know to expect them. And indeed this risk is often reflected in asset prices – riskier assets have a higher expected return than safe ones, and this difference is the required compensation for individuals to bear the extra risk.

However, there is a difference between expected risk and unexpected risk. Expected risk is factored into various things like prices (incentives) and seatbelts (mitigation). We have attempted to somewhat offset the downside that these possibilities might bring about, and still consider the activities worthwhile.

On the other hand, there are events which are truly unexpected – let’s call them unknown unknowns – or Taleb’s black swans. These are the earthquake and disaster at Fukushima, hurricane Katrina, and 9/11. These events are often not factored into risk expectations, and thus not prices. Thus when they happen they cause larger than expected moves in prices.

And in general, surprises are very rarely positive. We tend to “count or chickens before they hatch”, or assume that expected benefits will accrue over time. Thus re-adjustments downwards are more severe than adjustments upwards.

 

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