You only live once: our flawed understanding of risk helps drive financial market instability

December 17, 2010

Our flawed understanding of how decisions in the present restrict our options in the future means that we may underestimate the risk associated with investment decisions, according to new research by Dr Ole Peters from Imperial College London. The research, published today in the journal Quantitative Finance, suggests how policy makers might reshape financial risk controls to reduce market instability and the risk of market collapse.

Investors know that there are myriad possibilities for how a financial market might develop. Before making an investment, they try to capture these possibilities in a single number to represent likely market performance. They can do this in one of two ways: 'ensemble averaging,' which runs possible scenarios in parallel, or 'time averaging,' which runs scenarios in sequence.

The ensemble average is the most commonly used approach. It is based on imagining multiple scenarios that all begin from the same starting conditions, and then averaging their outcomes. The alternative, time averaging, imagines all possible scenarios playing out over time.

As we live on a timeline, previous decisions cannot be undone as time passes. Any new decision constrains our choices when making subsequent ones. Time averaging provides the more accurate prediction for the real world outcome of an investment decision.

Today's study shows that, in the investment world, the differences in the results from these two approaches are critical: time averaging inherently incorporates a measure of risk, but ensemble averaging does not.

This means that ensemble averaging consistently undervalues risk by underestimating the effects of time on investments and overestimating the degree of choice that investors have. It also encourages excessive leveraging of investments, which itself accentuates fluctuations in the market, increases market volatility, and imparts a negative drift in the market that helps drive investors into negative equity.

"In the investment world, ensemble and time averages give different results, with ensemble averages systemically ignoring the effects of fluctuations," said Dr Ole Peters, author of the study from the Department of Mathematics and Grantham Institute for Climate Change at Imperial College London. "If investors routinely used time averages, it would help to avoid scenarios such as the excessive leveraging of investments that contributes to market instability and the likelihood of market collapse."

The recent financial crisis clearly shows the effects of excessive leveraging used both between banks, and between banks and their borrowers. Investors using time averaging to calculate risk would require a good reason to exceed a leverage factor of 1. Leverage factors of 40-60, as used by some banks before the crisis, would ring alarm bells. Thus, time averaging could provide policy makers and regulators with an indication of the kind of ratios that we should expect in a healthy, robust investment market.

"Too often, investors behave as if they had access to different scenarios playing out in parallel universes whose outcomes they combine and average," explained Dr Peters. "This misleadingly encourages them to think they have more choice and face less risk than is actually the case. In reality, we are stuck in one universe and, as a consequence, time has a bigger effect on investment risk than we imagine."

"Finding more accurate ways to predict and manage risk will improve the way we prepare for and respond to extreme events, and will help our consideration of future risks due to a changing climate," said Professor Sir Brian Hoskins, Director of the Grantham Institute for Climate Change at Imperial College London. "In the wake of the financial crisis we are all aware of the fragility of the investment markets. This new research helps us understand why excessive risk-taking happens, how it destabilises the markets, and how regulators might better monitor and manage markets in the future".
-end-
Notes:

1. "Optimal leverage from non-ergodicity", Corresponding author: Dr Ole Peters, Department of Mathematics and Grantham Institute for Climate Change, Imperial College London. Download the study using this link: http://www.informaworld.com/smpp/content~db=all~content=a931328156~frm=titlelink

2. In some circumstances, ensemble and time averages are identical. These situations are referred to as 'ergodic'. Situations where time and ensemble averages are not identical are referred to as 'non-ergodic'.

The effect of time and ensemble averaging on the perception of risk in markets is shown by the following example of a market where share prices begin at 100, go up by 10% and then fall by 10%.

The ensemble average for this market would be 100 - namely the average of two parallel markets where in one market share prices fell by 10% (to 90) and in the other share prices rose by 10% (to 110). A time average for this market would be 99 - the shares rose by 10% (of 100) to 110, and then fell by 10% (of 110, that is 11) to 99.

The fluctuation of 10% affects the time average, reflecting the risk involved, whereas it has no impact on the ensemble average.

Imperial College London

Related Climate Change Articles from Brightsurf:

Are climate scientists being too cautious when linking extreme weather to climate change?
Climate science has focused on avoiding false alarms when linking extreme events to climate change.

Mysterious climate change
New research findings underline the crucial role that sea ice throughout the Southern Ocean played for atmospheric CO2 in times of rapid climate change in the past.

Mapping the path of climate change
Predicting a major transition, such as climate change, is extremely difficult, but the probabilistic framework developed by the authors is the first step in identifying the path between a shift in two environmental states.

Small change for climate change: Time to increase research funding to save the world
A new study shows that there is a huge disproportion in the level of funding for social science research into the greatest challenge in combating global warming -- how to get individuals and societies to overcome ingrained human habits to make the changes necessary to mitigate climate change.

Sub-national 'climate clubs' could offer key to combating climate change
'Climate clubs' offering membership for sub-national states, in addition to just countries, could speed up progress towards a globally harmonized climate change policy, which in turn offers a way to achieve stronger climate policies in all countries.

Review of Chinese atmospheric science research over the past 70 years: Climate and climate change
Over the past 70 years since the foundation of the People's Republic of China, Chinese scientists have made great contributions to various fields in the research of atmospheric sciences, which attracted worldwide attention.

A CERN for climate change
In a Perspective article appearing in this week's Proceedings of the National Academy of Sciences, Tim Palmer (Oxford University), and Bjorn Stevens (Max Planck Society), critically reflect on the present state of Earth system modelling.

Fairy-wrens change breeding habits to cope with climate change
Warmer temperatures linked to climate change are having a big impact on the breeding habits of one of Australia's most recognisable bird species, according to researchers at The Australian National University (ANU).

Believing in climate change doesn't mean you are preparing for climate change, study finds
Notre Dame researchers found that although coastal homeowners may perceive a worsening of climate change-related hazards, these attitudes are largely unrelated to a homeowner's expectations of actual home damage.

Older forests resist change -- climate change, that is
Older forests in eastern North America are less vulnerable to climate change than younger forests, particularly for carbon storage, timber production, and biodiversity, new research finds.

Read More: Climate Change News and Climate Change Current Events
Brightsurf.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.