You only live once: our flawed understanding of risk helps drive financial market instability

Our flawed understanding of how decisions in the present restrict options in the future means that we may underestimate the risk associated with investment decisions, according to new research -<em> News release</em>

Imperial College London News Release

For immediate release
Friday 17 December 2010

Our flawed understanding of how decisions in the present restrict our options in the future means that we may underestimate the risk associated with investment decisions, according to new research by Dr Ole Peters from Imperial College London. The research, published today in the journal Quantitative Finance, suggests how policy makers might reshape financial risk controls to reduce market instability and the risk of market collapse.

Investors know that there are myriad possibilities for how a financial market might develop. Before making an investment, they try to capture these possibilities in a single number to represent likely market performance. They can do this in one of two ways: 'ensemble averaging,' which runs possible scenarios in parallel, or ‘time averaging,’ which runs scenarios in sequence.

The ensemble average is the most commonly used approach. It is based on imagining multiple scenarios that all begin from the same starting conditions, and then averaging their outcomes. The alternative, time averaging, imagines all possible scenarios playing out over time.

As we live on a timeline, previous decisions cannot be undone as time passes. Any new decision constrains our choices when making subsequent ones. Time averaging provides the more accurate prediction for the real world outcome of an investment decision.

Today's study shows that, in the investment world, the differences in the results from these two approaches are critical: time averaging inherently incorporates a measure of risk, but ensemble averaging does not.

This means that ensemble averaging consistently undervalues risk by underestimating the effects of time on investments and overestimating the degree of choice that investors have. It also encourages excessive leveraging of investments, which itself accentuates fluctuations in the market, increases market volatility, and imparts a negative drift in the market that helps drive investors into negative equity.

"In the investment world, ensemble and time averages give different results, with ensemble averages systemically ignoring the effects of fluctuations," said Dr Ole Peters, author of the study from the Department of Mathematics and Grantham Institute for Climate Change at Imperial College London. “If investors routinely used time averages, it would help to avoid scenarios such as the excessive leveraging of investments that contributes to market instability and the likelihood of market collapse."

The recent financial crisis clearly shows the effects of excessive leveraging used both between banks, and between banks and their borrowers. Investors using time averaging to calculate risk would require a good reason to exceed a leverage factor of 1. Leverage factors of 40-60, as used by some banks before the crisis, would ring alarm bells. Thus, time averaging could provide policy makers and regulators with an indication of the kind of ratios that we should expect in a healthy, robust investment market.

"Too often, investors behave as if they had access to different scenarios playing out in parallel universes whose outcomes they combine and average," explained Dr Peters. "This misleadingly encourages them to think they have more choice and face less risk than is actually the case.  In reality, we are stuck in one universe and, as a consequence, time has a bigger effect on investment risk than we imagine."

"Finding more accurate ways to predict and manage risk will improve the way we prepare for and respond to extreme events, and will help our consideration of future risks due to a changing climate," said Professor Sir Brian Hoskins, Director of the Grantham Institute for Climate Change at Imperial College London. "In the wake of the financial crisis we are all aware of the fragility of the investment markets. This new research helps us understand why excessive risk-taking happens, how it destabilises the markets, and how regulators might better monitor and manage markets in the future".

For further information please contact:

Simon Levey
Research Media Officer
Imperial College London
email: s.levey@imperial.ac.uk
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Notes to editors:

1.   "Optimal leverage from non-ergodicity", Corresponding author: Dr Ole Peters, Department of Mathematics and Grantham Institute for Climate Change, Imperial College London. Download the study using this link:
http://www.informaworld.com/smpp/content~db=all~content=a931328156~frm=titlelink

2.   In some circumstances, ensemble and time averages are identical. These situations are referred to as 'ergodic'.  Situations where time and ensemble averages are not identical are referred to as 'non-ergodic'.

The effect of time and ensemble averaging on the perception of risk in markets is shown by the following example of a market where share prices begin at 100, go up by 10% and then fall by 10%.  

The ensemble average for this market would be 100 - namely the average of two parallel markets where in one market share prices fell by 10% (to 90) and in the other share prices rose by 10% (to 110).  A time average for this market would be 99 - the shares rose by 10% (of 100) to 110, and then fell by 10% (of 110, that is 11) to 99.

The fluctuation of 10% affects the time average, reflecting the risk involved, whereas it has no impact on the ensemble average.

3.   About the Grantham Institute for Climate Change

The Grantham Institute for Climate Change is committed to driving climate change related research and translating it into real world impact. Established in February 2007 with a £12.8 million donation over ten years from the Grantham Foundation for the Protection of the Environment, the Institute's researchers are developing both the fundamental scientific understanding of climate change, and the mitigation and ad aptation responses to it.

The Institute intends that this work should be directly relevant to policy and decision makers. The Grantham Institute is uni que among climate change research centres because it is situated at the heart of Imperial College London, one of the world's leading science, technology and medicine universities. The policy and outreach work that the Institute carries out is based on, and backed up by, the leading edge research of the College's academic staff.

Website: www.imperial.ac.uk/climatechange

4.   About Imperial College London

Consistently rated amongst the world's best universities, Imperial College London is a science-based institution with a reputation for excellence in teaching and research that attracts 14,000 students and 6,000 staff of the highest international quality. Innovative research at the College explores the interface between science, medicine, engineering and business, delivering practical solutions that improve quality of life and the environment - underpinned by a dynamic enterprise culture.
   
Since its foundation in 1907, Imperial's contributions to society have included the discovery of penicillin, the development of holography and the foundations of fibre optics. This commitment to the application of research for the benefit of all continues today, with current focuses including interdisciplinary collaborations to improve global health, tackle climate change, develop sustainable sources of energy and address security challenges.

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