2016 has dealt a blow to certainty. Or it certainly should have.
Just a few weeks ago, the experts were telling us that Hillary Clinton was certain to be the next President of the United States.
Depending on the prediction source or betting market, the odds of a Clinton victory were anywhere from a low of 65% to a preposterous high of 99%. One betting outlet, PaddyPower, for some unfathomable reason, paid off bets on Hillary three weeks ahead of the election. Those who suggested Trump could win were ignored or, more often, roundly mocked. Articles even began to appear explaining the Trump “loss” and the lessons that could be learned from his unsuccessful strategy.
Of course, we all know the punchline. And we were all treated to the sight of the expert opinion executing a slow, graceful, if somewhat muted U-turn over the course of several hours on the evening of November 8th.
The entire episode would have been a shock had it not played out, on a similar timeline and trajectory, four and a half months earlier in the U.K. There, the referendum on Britain leaving the E.U. was projected to lose by between 2 and 4%, right up until the moment it won by 3%.
What we accept as unchanging truths can change quite quickly. Just a few years ago, we were told that low fat / high carbohydrate diets made you thin. And we were also told the banking system was sound because the real estate underlying loans could never drop in value.
And despite these reverses, we cling to certainty. Prediction has been described as the brain’s primary function, so we aren’t about to stop. Uncertainty triggers the fight or flight response, while certainty makes us feel warm and calm. Some have suggested we are actually addicted to certainty. As we are only intermittently rewarded with being right, our addiction is strengthened.
Businesses pay handsomely for experts to tell them what’s coming. Economists’ models (especially when the results of those models are averaged) are highly accurate in normal economic conditions, but routinely miss the turning points. The models’ precision is meaningless, though, as the turning points are the only information we really need. It does not really help to know that GDP will rise 3.3% instead of 3.1%. It would be much more useful to know a recession is coming, but the models always get that part wrong.
Just because we really want to know what will happen next, doesn’t mean we can or will. Moreover, clinging to assurances can actively harm us, our lives, and our economy.Recognizing the limits of our ability to forecast could leave us healthier, safer and richer. click to tweet this
Consider the impact of perceived certainty on investment and business decisions.
When corporations and investors operate with a perception of high certainty, we often see:
|Increased leverage||Risk premiums on investment are lower, leaving leverage as the only means of achieving decent returns on equity.|
|Over-concentration||If outcomes are known (or we think they are known), investors will concentrate on those investments expected to pay off.|
|Lack of hedging||With low and leveraged returns, the cost of hedging investments may eat up too much of anticipated profits.|
|Crowded investments||Everyone has the same position, so it is both more expensive to hedge and there is a rush for the exit if there are indications things may reverse.|
When uncertainty is high, we find more constructive behavior:
|Debt reduction||Instead of leverage to enhance low risk premia, we might see reduced borrowing and returns from higher risk premia. The odds of default decline. Credit lines remain untapped and are available if and when opportunities arise.|
|Cost savings||While one may not be certain of revenues, one can be certain of spending levels.|
|Small, diverse bets with larger payoffs||Not only is an investor unsure what will work, he or she cannot rule out what not work. “Risky” investments might pay off because the range of possible outcomes is broad.|
|Hedging||Risk premia may support hedging. Also, if fewer people are concentrated on the same investments, there could be investors interested in the opposing side of a hedging trade, as this could be hedging their position.|
Of course, these tables somewhat overstate the case. And people do insure against uncertain outcomes all the time. We have, however, seen significant movement toward the “certainty investments” in recent years.
So, maybe this has all been good. Maybe people will stop hiding their heads under the blanket of false security and start dealing head on with a world in which the unknown and unknowable play a significant role. Then again, maybe not.