Financial markets are driven by changes in expectations. If markets are efficient and investors have rational expectations, at the extreme, prices will only move when there is new information or unanticipated surprises to the market. Unanticipated shocks are the key driver of volatility. Yet, there has been little discussion on the sources of surprise in markets. Not what are the surprises but the reason for a surprise. We have uncovered an old topology map of surprise classification which we think is very useful for any investor.
The figure is a very general approach, but provides some good insights between outcomes which are known and those which are not known or driven by ignorance. If possible outcomes are known, investors are faced with risk. The probabilities are known, but we may not know the actual result. The alternative is that events will occur and the possible outcomes are known but the probabilities are not know. A simple case is an economic announcement. The date of the announcement is know and we may have a likelihood of what will happen when the new information enters the market. If those probabilities are known, we are facing risks. If the model of what the market reaction will be to an announcement, we are facing uncertainty.
The alternative direction of surprise is that the outcomes are not known and we are faced with a form of ignorance. Ignorance can be reduced through learning on a personal level or through analysis on the communal level. If we are not willing to learn, we will have closed ignorance. While not shown on the chart, you would move back to the known outcome section if there is effective learning. If we cannot reduce ignorance, an investor is faced with two problems. The view of world may be wrong or the solution is not knowable.
This breakdown provides structure for dealing with surprises and how an investor can potentially minimize surprises and the potential impact. Learning is critical, but it must be focused.
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