As we have seen, statistical regularities recorded over calm periods can fundamentally lead to an underestimation of risk. Consequently, investors are repeatedly surprised by “improbable” market developments. We believe that the key for building a more comprehensive investment and risk management toolbox can be found through a multidisciplinary approach to economics.
In this white paper, Cardano Insights explores new ways that can make investment outcomes more robust by looking at the world through the lens of complexity economics.
The three main chapters presented in this paper are:
- “I got this” – says the model: Mainstream quantitative models can provide decent estimates of risks during stable periods. However, during more extreme events, these models can fail to capture all of the risks that come to light. Before the storm, the economy becomes increasingly fragile. Inevitably, the economy reaches a tipping point where a small shock throws it into the unknown. These shocks are reinforced by the feedback loops created by investors. In such a system, investors’ expectations and biases, together with strategic responses to financial innovation and central bank policy, can largely describe the type of tail events we see in reality. All these aspects of the economy can be captured by Complexity Economics.
- The devil is in the tail: Assuming normality of returns and neglecting consideration of tail risk, were only a few aspects that models omitted before the crisis. Rather than focusing on better approximating the exact probabilities of extreme events, investors can first consider the underlying economic processes that may lead to stable or unstable outcomes. While economic behaviour cannot be accurately predicted, Complexity Economics does acknowledge that certain patterns do emerge over time and so qualitative predictions can be made. Investing, for example, according to where the economy is in the credit cycle allows investors to take up risk when it is rewarded the most.
- When your problems are my problems: The interconnectivity of the financial system can lead to substantial miss-assessment of the underlying exposures, and ultimately domino effects when shocks occur. Complexity Economics sheds light on these domino effects using network theory, identifying the most interconnected institutions to assess their risk exposures and to ultimately gauge the fragility of the economy. Understanding when the economy is fragile, can allow investors to assess when to take to take more risk and when to de-risk their portfolio.
The article concludes that the insights stemming from Complexity Economics can be used to help investors navigate an ever more complex economy.
The full article is available here.