Sunday, October 6, 2019

Frank Knight's ideas applied to finance and money management - Profits come from uncertainty

Frank Knight wrote his most important book Risk, Uncertainty and Profit in 1921. It has shaped thinking on the key concept of risk and uncertainty but many followers of thinking on risk and uncertainty miss his points on profits which are the real core to the book. The crux of his book is not just to define risk and uncertainty but also to use these concepts to think about profits and competition. In a perfectly competitive environment, profits will be driven to zero. Profits are actually driven by the pay-offs to uncertainty. Hence, profits cannot be controlled or managed in a competitive market.

In the financial world, competition makes markets efficient. There is no excess returns or profits outside of the compensation for risk. There may be a return for risk taken, a risk premia, but competition will drive any excess returns to zero. This is just like Knight's thinking about profits in a competitive industry. The return on investment will be equal to the cost of managing that investment and taking on risks. 

Nevertheless, reality in either a competitive market or a financial market is different than the stylized frictionless world. There can be excess returns associated with uncertainty but these returns will be fleeting or random. Like any competitive market, there is little room for enduring skill over luck. From Risk, Uncertainty, and Profit:
"The primary attribute of competition, universally recognized and evident at a glance, is the “tendency” to eliminate profit or loss, and bring the value of economic goods to equality with their cost…. But in actual society, cost and value only “tend” to equality; it is only by an occasional accident that they are precisely equal in fact; they are usually separated by a margin of “profit,” positive or negative. Hence the problem of profit is one way of looking at the problem of the contrast between perfect competition and actual competition."

Under a competitive world, Knight says that profits are unpredictable and associated with uncertainty and not risk-taking that is measurable and can be hedged. Profit comes from taking on uncertainty that by definition cannot be calculated. Sometimes uncertainty is favorable and a profit is gained and sometimes it is unfavorable and the firm incurs a loss.
“Profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated and then only in so far as even a probability calculation in regard to them is impossible and meaningless.”

In this world, investors cannot be smug about their superior trading skill. It is usually luck. What a manager perceives as skill is just luck from uncertain outcomes. For Knight, if you do have consistent good judgment it would be from the hard work of trading and be considered a wage.
"The receipt of profit in a particular case may be argued to be the result of superior judgment. But it is judgment of judgment, especially one’s own judgment, and in an individual case there is no way of telling good judgment from good luck, and a succession of cases sufficient to evaluate the judgment or determine its probable value transforms the profit into a wage."

The Knightian concept of profit is somewhat foreign to most students of economics. Discussing perfect competition and profitability in finance is also foreign not because of the concepts but because of differences in language. Exploring the differences between risk and uncertainty deepens our understanding of return and profitability.

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