Stories are important models yet flawed

“Partial knowledge is more often victorious than full knowledge: it conceives things that are simpler than they are and therefore makes its opinion easier to grasp and more persuasive."    - Nietzche 

"History will justify anything. It teaches precisely nothing, for it contains everything and furnishes examples of everything."

- Paul Valery 

Storytellers are model builders. There is a need to describe the causal basis of experiences. A stream of events needs some causal explanation or sense-making that is realistic and comprehensible. A story will use stylized facts to support an argument, but stories are not the same as models. It is process of causal inference that is not always based on empirical testing from large samples of data. 

Stories are especially important when there is limited data for analysis or there is a high degree of uncertainty. In an environment of radical uncertainty or complexity, a story or narrative is a useful tool to describe the environment and make sense of causal relationships. 

Organizations use stories to help explain their actions. The story will serve as a model for how an organization behaves. nevertheless, these stories are focused on some mythical themes: rationality, hierarchy, individual leader significance, and historical efficiency.

The story can be flawed, so investors have to question the underlying assumptions associated with any story no different than how model assumptions are reviewed and tested. Stories should be reviewed through a rigorous process to ensure flawed logic based on partial knowledge is avoided.  

The two components of investor intelligence

We can think of two components of intelligence. Both are needed to be an effective trader or investor. First, an intelligent person needs to effectively adapt to an environment. Resources are needed manage the environment so an individual must have  the capability to know how to use these resources. There is required knowledge about the world and the ability to make decisions. Second, there is a need to Interpret experiences within an environment. The skill to provide meaning and learn. The link between these two forms of intelligence is experiential learning. 

Intelligence is about adaptation, which may involve low intellect, where success is obtained through limited effort and causal understanding, or high intellect, which is associated with a need to understand the causal structure.

This leads to three forms of intellectual adaptation will lead to rules and heuristics. The second is harder because rules may not work especially if the environment is dynamic. The second is imitation, where one actor follows another's success. The third mechanism is selection, which reproduces attributes associated with prior success and eliminates those associated with failure. Yet, controlling or managing the investment environment is difficult.

Success in controlling an environment is limited because history is complex and stochastically uncertain, and outcomes depend on the sequence of choices that lead to a specific action. Success is impacted by the sample of experiences and the sample of outcomes. 

Intelligent investing is more than application of models but an attempt to control a complex environment that requires understanding, action, and learning.

The ambiguities of experience - impacts decision-making

 

James March is one of the great professors of organizational management, yet finance and investment professionals rarely discuss or even consider much of his work. This is odd because organizations, not individuals, make so many investment decisions. Organizations through investment committees are a key driver of all institutional action. Organizations manage risk and provide oversight of individual managers.

In his older book, The Ambiguities of Experience, March focuses on the paradox that experience "may be the best teacher" but "is not a particularly good teacher". Organizations are driven by their experiences, yet the links between action, decision, outcome, and learning are often not clear. The problem is that there are a number of ways to interpret the link between action and outcome. We have discussed this before in our work on “wicked” environments. 

Experience can be noisy because there are a number of links with any action. We cannot always say that our action caused an outcome. Our experiences are also selective. We will often focus on the decisions we made that turned out to be correct and dismiss our incorrect actions. Similarly, success and failure can be misleading. If something worked well, we will likely repeat it. If some action fails, we are likely to stop, yet this stopping rule may not be correct when there are probabilistic outcomes. Additionally, the world changes, so the lessons in the past may not apply, and our aspirations of what is successful also change. There is ambiguity because the environment is complex, noisy, endogenous, constructed, and miserly from small samples.

Experience may not contain the correct lessons for investors or traders. There is ambiguity about what happened, why it happened, whether it was good or bad, and whether our actions affected the results. There is superstitious learning that just because some action of ours is followed by some result, the takeaway is that we did that. Is experience unreliable? No, but it should be tempered. 

The key issue for investors and any asset management organization is that causal inference is difficult. The problem permeates all organizations and inference is not an issue that is left to science. Organizations like individuals will have behavioral biases associated with group action and decisions. Organizations have to engage in exploration to learn and then engage in a conversion into exploitation or the action from the learning. 

Are global reserves moving away from the dollar?

The share of dollars has been declining, but not consistently across countries. Some have increased their dollar share while others have reduced their dollar exposure. In a NY Fed blog posting, “Are Central Banks Moving Out of Dollar Assets?” the authors try to disentangle the problem through two channels. One is the preference channel, which represents a change in the desire to hold a specific currency. For example, it can be a desire to hold fewer dollars. The second channel is the reserve change channel, which represents a change in the overall amount of reserves held. If a central bank has less dollar exposure but increases its overall reserves, overall dollars held will decline when central bank data is aggregated. 

What is clear is that the change in preferences has centered on a limited number of large central banks and does not represent a shift in behavior across all reserve holders. Second, some of the decline in the dollar share of foreign reserves is caused by large reserve holders that have had a lower allocation of dollars but have seen an increase in overall reserves. 

In conclusion, dollars as a percent of all reserves have declined over the recent reporting period, but the reasons for the decline suggest it is not a wholesale rebalancing of dollar exposure.