Rethinking Markets

In reading Yuval Millo’s “Mechanics of Performativity”, I’m struck once again by the Black-Scholes notion of risk-free portfolios. There is a fundamental assumption, crossing a wide range of financial products (and, even as I’m venturing into the Art markets, economic reasoning there), about the relationship between risk and reward.

The basic idea is that investment ought to be compared not against 0% return, but against the return of so-called ‘riskless’ investment, usually in treasury bonds or some other interest-bearing account. Which is usually fine, and I normally accept it as reasonable. But not today. Today, I am reading Millo against the backdrop of James March’s Primer on Decision Making. A dry but fascinating book, March makes the following observation (pp 47-48):

…there appears to be a tendency for human subjects to assume that extremely unlikely events will never occur and that extremely likely events will occur…Consider an event of great importance to an organization and very low probability. Individuals in the organization can be expected to estimate the probability of the event and to update their estimates on the basis of their experience.

This seems critical in assessing the finance assumption of risklessness in an interest-bearing account. The odds of the US defaulting on its bonds, or a bank going bankrupt with no possibility for repayment are, it seems to me, extremely low but non-zero. It would require any number of particularly rare events to occur. But, as March notes,

“many of these very unlikely events would have very substantial consequences if they were to occur, and…although each one of these events is extremely unlikely to occur, the chance of none of them occurring is effectively zero. Predicting precisely which extremely unlikely event with important consequences will occur is impossible, but some such event will almost certainly occur. Yet plans tend to ignore all such events. As a result, plans are developed for a future that is known (with near certainty) to be inaccurate.

The problem is actual even worse than this. Even if emergency plans are in place, most people never experience the event (it is, you know, rare after all), they come to think the system is more reliable than it actually is. And they tend to become more lax about maintaining these plans in the face of ‘almost never’ likelihood.

What to take from this? I think there is a good chance that we’ll experience some financial crisis that will be both systemic and unforeseeable, at least until after the fact. And then we’ll look back at it and see how our assumptions that this could ‘never’ happen are just wrong..