Misunderstood risks in investment drive financial market instability: Study

Saturday, December 18, 2010

WASHINGTON - According to a new study, our incomplete or incorrect understanding of how decisions in the present affect future options means that we may underestimate the risk associated with investment decisions.

Dr Ole Peters from Imperial College London suggests how policy makers might reshape financial risk controls to reduce market instability and the risk of market collapse.

Before investing, investors 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. Time averaging imagines all possible scenarios playing out over time. It provides the more accurate prediction for the real world outcome of an investment decision.

The new 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.

“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,” said Peters.

The recent financial crunch is an example. It 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. 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,” said Peters.

The research is published today in the journal Quantitative Finance. (ANI)

Filed under: Business

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