Conventional financial market theory argues that asset prices change when random surprises cause investors to reappraise their valuations. This suggests we cannot anticipate future price movements but we can at least calculate the probability of how an asset’s price could move. This view of risk is rather like that involved in rolling dice: we don’t know which numbers we will get but we do know which numbers we could get. This is the type of risk Donald Rumsfeld famously described as ‘known unknowns’, and it is neatly portrayed by the probability distributions underpinning many value-at-risk calculations.
A more enlightened understanding of financial market behaviour recognises asset prices are often driven by self-reinforcing processes, spurred on by the effects of financial cycles and our human herding tendencies. From this more sophisticated perspective, financial risk can be seen as akin to the behaviour of flocking birds, being neither random nor predictable. In this self-reinforcing complex world risk is much harder to quantify and extreme price movements, described by so-called ‘fat-tailed’ distributions, become more likely. This is the flavour of risk Donald Rumsfeld would have called the ‘unknown unknowns’.
At Equitile we believe complex self-reinforcing behaviour dominates financial markets, especially during financial crises. This is why we believe conventional value-at-risk systems often suffer the ‘chocolate teapot’ problem – they appear to work but fail when needed most. It is this view of financial risk that drives every aspect of our investment philosophy and process.