risk

Most people have an intuition that uncertainty can harm economic outcomes. Baker, Bloom, & Davis (2016) and Bloom (2009) demonstrated that industrial production and manufacturing decline in the face of policy uncertainty. The typical mechanism that people suggest is that uncertainty about the future causes people to engage in precautionary saving, resulting in fewer sales.

The theory continues that firms consequently decrease production as demand for their output declines. Firms aren’t interested in causing the quantities supplied and demanded to be equal. Rather, they don’t want to produce too many goods that don’t get sold or don’t get sold at an adequate markup. Production is costly. A related theory is that more persistent or longer-run uncertainty can also depress investment, since the riskier future increases the tail risk of losses.

Rather than make a risky investment, one could instead just hold off and wait for some of that uncertainty to get resolved. There’s tradeoffs to this, of course. As future costs and benefits become clearer, they also get priced-in to asset values. So, there is an optimization problem. The possible downside outcome is big and uncertain. If the risk of the investment gets resolved and the downside outcome is still too likely or harmful, then a project manager did the ex-post ‘right thing’ by waiting.

But, if the downside risk disappears or is found to be very small, then waiting to invest in the project incurs an economic cost. Either 1) the profitable project and its associated profits will occur later and less valuably, or 2) other firms also resolve their uncertainty and bid up the price of the project’s inputs. Invest too early, and the downside is large and uncertain. Invest too late, and you may lose the potential upside partially or entirely.

But can uncertainty systematically increase profits?

Walter Oi said yes.

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Hopefully by this time we all know about index funds. The idea is that by investing in a large, diversified portfolio, one can enjoy the average return across many assets and avoid their individual risk. Because assets are imperfectly correlated, they don’t always go up and down at the same time or in the same magnitude. The result is that one can avoid idiosyncratic risk – the risk that is specific to individual assets. It’s almost like a free lunch. A major caveat is that there is no way to diversify away the systemic risk – the risk that is common across all assets in the portfolio.

We can avoid the idiosyncratic risk among assets. But, we can also avoid idiosyncratic risk among times. Each moment has its own specific risks that are peculiar to it. Many people think of investing as a matter of timing the market. However, people who try to time the market are actively adopting the specific risks that are associated with the instant of their transaction. This idea seems obvious now that I’m writing it down. But I had a real-world investing experience that– though embarrassing in hindsight – taught me a heuristic for avoiding overconfidence and also drilled into my head the idea of diversifying across time.

I invested a lot into my preferred index fund this past year. I’d get a chunk of money, then I’d turn around and plow it into the fund. What with the Covid rebound, it was an exciting time. I started paying more attention to the fund’s performance, identifying patterns in variance and the magnitude of the irregularly timed and larger changes. In short, by paying attention and looking for patterns, I was fooling myself into believing that I understood the behavior of the fund price.

And it’s *so* embarrassing in hindsight. I’d see the value rise by $10 and then subsequently fall to a net increase of $5. I noticed it happening several times. I acted on it. I transferred funds to my broker, then waited for the seemingly regular decline. Cha-ching! Man, those premium returns felt good. Success!

Silly me. I thought that I understood something. I got another chunk of change that was destined for investing. I saw the $10 rise of my favorite fund and I placed a limit order, ensuring that I’d be ready when the $5 fall arrived. And I waited. A couple weeks passed. “NBD, cycles are irregular”, I told myself. A month passed. And like a guy waiting at the wrong bus stop, my bus never arrived. All the while, the fund price was ultimately going up. I was wrong about the behavior of the fund. Not only did I fail to enjoy the premium of the extra $5 per share. I also missed what turned out to be a $10 per share gain that I would have had if I had simply thrown in my money in the first place, inattentive to the fund’s performance.

Reevaluation

I hate making bad decisions. I can live with myself when I make the right decision and it doesn’t pan out. But if I set myself up for failure through my own discretion, then it hurts me at a deep level. What was my error? Overconfidence is the answer. But why did it hurt me?

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