The era of sudden shocks - we don't have an explanation

A recent FT article by Robin Wigglesworth highlights the thought that we are in a period of sudden shocks or short bursts of uncertainty. While economic volatility has declined, as described by the Great Moderation, even with the Global Financial Crisis (GFC) and COVID-19, there have been short-term shocks in financial volatility. The current volatility, as measured by the VIX, is close to the long-term average. Still, the volatility of vol is elevated, and there are these periods of volatility shocks. 

Is there an explanation for this vol shock environment? There is no easy answer. It could be related to the higher leverage in the marketplace, but that does not explain the short-term nature of these shocks. It could be quick policy responses, but there have been more short-term spikes than Fed responses. It could be what a friend has referred to as the "wall of money" that will invest when there is a short-term reversal. That could be a reasonable explanation, yet it does not explain why we have the shocks in the first place. 

The investment implications for this are worth reviewing. Currently, it states that investors should not be concerned about these shocks, even if they are frequent. For some strategies, such as trend-following, it is a negative outcome where managers get whipsawed by these spikes. Trading strategies require more activity, not less. 

 

Paul Slovic - there is a difference between risk as feeling and risk as analysis

Paul Slovic, one of the leading behavioralists in the field of decision-making, stated that there is a distinction between risk as a feeling and risk as an analysis. This is his way of thinking about the fast and slow thinking problem as described by Dan Kahneman. Risk, as feelings, is our natural reaction to danger, which could be called our jumpiness when faced with a risk. It can also be described as our experiential system. This is in contrast to risk analysis, which examines decisions under uncertainty as an analytical issue of measuring costs and benefits. 

While most investors will always focus on fast and slow thinking, the Slovic approach is a nice addition or contrast to what we already know about decision-making.

From Risk as Analysis and Risk as Feelings: Some Thoughts about Affect, Reason, Risk, and Rationality

The difference between certainty and uncertainty

Certainty - firm conviction, with no doubts, that something is the case

Uncertainty - the conscious awareness of ignorance 

-from The Art of Uncertainty by David Spiegelhalter 

All investors deal with issues of certainty and uncertainty. Importantly, there is no certainty. Get that out of your head. We live in a world of probabilities from what is countable and a world of uncertainty based on ignorance. Uncertainty is foremost what we do not know, so the job of any analyst is to reduce uncertainty from ignorance. There is some uncertainty that we will not be able to fully learn our way out. In those cases, we have to make some subjective probabilistic judgments. 

All investment research is about reducing uncertainty and increase the precision of our probabilistic estimates. 

What makes a good forecaster from Dan Gardner

Dan Gardner,  an essential writer on forecasting, states that there are three key components to being a good forecaster. 

Aggregation - Good forecasters are great aggregators of information and other opinions. They will utilize all available information, even if it contradicts their current views. They will seek out alternatives. They are open to small ideas and not a single unifying thesis. 

Meta-cognition - They are good probabilistic thinkers who also take into account their own biases. They are fully aware of decision bias and reflect on whether they are engaging in these biases. Hence, they never rush to judgment.

Humility -  Good forecasters will admit when they are wrong. Hence, they show a significant amount of humility in their work. They do not have to prove they are right. They can accept error and then try to adjust. 

Use these three components as a checklist to ask whether you are making good forecasts.