Complexity and uncertainty within asset management

Uncertainty goes hand-in-hand with complexity, but they are not the same thing. Investors should understand the trade-off between these two and what is the impact on decision-making when there is increasing uncertainty or complexity. We define complexity as the number of factors needed to explain a given event. Simple events are easy to explain with simple stories and a limited number of factors. 

Events that may need a model that requires more explanatory variables is inherently more complex. Given that macroeconomic cannot be easily explained by one or two factors, we would call it complex. The drivers of currency are inherently complex. An individual stock which can be explained by discounted cash flows which are stable would be considered a low complexity system.

If there is low complexity and low uncertainty, we are living in a simple world of facts. We can describe the world as a simple place where A implies B. When the complexity gets larger and there is more uncertainty, we have to form predictions because we are not sure of the interaction between factors and results. There could be three factors, A, B, and C which effect a market. We may not know the chance of one of the variables changing and we may not know the interaction between A, B, and C. We have to make some predictions. There is more uncertainty and complexity.

As the world becomes more complex and uncertainty, we move into a world of projections and scenarios. There is not a clear link between factors and results. There is more story-telling. We have to start describing "what-if" possibilities with variables that may not be easily countable. If there is high uncertainty and complexity, we may not know the factors that could drive markets and we may not know when they will occur. We are in the realm of speculation.

All this may seem obvious, but classifying the environment and when we may move between speculations and predictions is important. The systematic manager wants to keep the complexity low through limiting the number of factors review. High complexity will more likely require speculations. High uncertainty means key factors may not be knowable and again require high speculation. Knowing the amount or form of uncertainty and complexity can help define the amount of risk that should be taken.