The problem with SEU subjective expected utility

 

How do investors deal with uncertainty? This is a critical question, perhaps the key question for investing, yet it is often overlooked. Of course, there are many answers to this question, but the fundamental problem is how do investors form expectations about uncertain events.  The answer to dealing with uncertainty is to form better expectations of the future.

The investor must first isolate what is the event, and second, the investor must form some probability associated with the likelihood of that event. In return space, the problem can be simplified through just giving different returns some probabilities and have the probabilities sum to one. Once an investor tries to describe specific events, the issues get much harder. 

The response from a technical perspective is to use some form of subjective expected utility (SEU) as a framework. The problem is just multiplying probabilities times events with a set of rules for behavior to generate the probability formation. We have all used this type of framework, yet there is something missing when trying to apply it in real life settings. 

Where do those probabilities come from? This is again easy if you have countable events, that is, if we use some probability distribution that comes from the sampling of past return. The problem is less tractable if we are trying to incorporate events that have not occurred in the past within our sample of return. 

The problem also becomes more difficult if we try and map events or shocks into the return space. If we have an event, say an earthquake or hurricane, we must both think about the likelihood of the event, the type of event, and the mapping of the event to specific asset returns. It may sound easy; however, the work involved is difficult. This is the process that is often not discussed in the classroom. 

So how are probabilities formed for non-countable or rare events? They are subjective and rely on the decision-maker. We assume that he will be rational and have a process that is consistent, but beyond consistency, there is little work on how these subjective likelihoods are formed.

 There is uncertainty over the process of forming likelihoods of uncertain events. Perhaps that is why rules of thumb are developed and we try our best to in the words of Herb Simon satisfice.