Book

The following is an except from my manuscript

This book provides an analytical frame for explaining how investors make decisions in increasingly complex and interdependent global financial markets. It argues that ambiguity is both the cause of and the solution to poor investment decision-making. This perspective rests on the view that ambiguity is conceptually distinct from uncertainty. Unlike uncertainty, ambiguity is not a problem of missing information; it is a problem of interpretation. I show that finance theory conflates ambiguity with uncertainty. In doing so, finance theory maintains that the world can be carved up into events that are characterized by risk and by uncertainty that can be reduced to risk. But such a perspective ignores the impact of increasing linkages between issues such as resource scarcity, climate change, physical infrastructure and technological innovations on an investor’s ability to manage risk. Understanding ambiguity is critical to managing the growing number of risks that cannot be traced to their direct causes.

In his widely acclaimed book Against the Gods, Peter Bernstein declares that distinguishing modern times from thousands of years of history is our mastery of risk. Indeed, intellectual advancement in theories of probability and the science of decision-making over the past two centuries has provided the finance industry with the tools necessary to impose some degree of order on an uncertain environment. But Bernstein has told only the first half of the story. The second act is just beginning to unfold.

If the mastery of risk and uncertainty defines modern times, what will surely define us going forward is how we cope with complexity. Indeed, since Bernstein wrote his story of risk two decades ago excessive securitization and extreme global connectivity have drastically increased the complexity in global financial markets. The risks arising from individual firms, physical infrastructure and the natural environment have become increasingly difficult to disentangle from each other.[1] Paradoxically, the standards, rules, norms and instruments that we have used to master risk in the first act have created many of the problems in the second act. For example, benchmarks used to measure performance in the financial world have led to herd behaviour.[2] Similarly, financial instruments used to hedge against risks have eroded distinctions between different financial products, making it increasingly difficult to distinguish between financial intermediaries.[3] We have entered a new risk environment.

The recognition of this new risk environment has inspired some scholars to use biological analogies to explain complex economic patterns. Flocking birds are used to explain the emergence of complex economic interactions. Similarly, animal anatomies are used to explain the interdependent qualities of the economy. But curiously, for a heterodox branch of economics that is seeking a radical shift from the way that economics is theorized, complexity and evolutionary economics rely on analogies from natural sciences (this time biology instead of physics) to explain market outcomes. The problem with this approach is that finance is not a natural science. As the economist Ludwig von Mises explains, markets are a consequence of human action.

Human action is purposeful. Humans are not passive animals merely reacting to stimuli in the environment; we are reflexive actors. This means our environment does not only shape our decisions; we also contribute to shaping our environment. Using biological analogies to reason about human decisions discounts the social properties of being human. To better understand human decisions in complex environments we must turn to disciplines in the social sciences. These disciplines take seriously the variegated nature of economic and social interactions that shape economic outcomes. For example, geography draws attention to how space influences liquidity preference and contracting, among other economic decisions. Sociology draws attention to how past interactions and identities shape future patterns. Psychology draws attention to how decisions are context-dependent. At the heart of understanding this variegation in our social and economic interaction is ambiguity. Ambiguity is a psychological state of having more than one way of interpreting information, contracts, rules, and other structures that seek to govern social and economic life.

This book tells the story of ambiguity. In many ways, it writes over Peter Bernstein’s story of risk and uncertainty to make room for ambiguity. Ambiguity reflects our attempt to deal with complexity when we cannot work out exactly what we mean. Ambiguity allows us to adapt to emerging contexts by re-interpreting existing rules, norms, policies and contracts. Ambiguity allows us to reach agreement with others while maintaining different reasons for agreeing. I demonstrate the applications of ambiguity to a range of complex problems facing asset owners and firms in the financial industry. I explore ambiguity in domains such as law, philosophy, sociology, art, poetry, political science, mathematics and history. I find that these domains have achieved major theoretical innovations that have allowed them to explain the complexities in their environment by accepting, rather than by denying, ambiguity. In contrast, finance theory has clung to a false sense of certainty. In doing so, it has evaded the evolution needed to reconcile theory with practice in a rapidly changing landscape.

For many readers, the significance of ambiguity will seem trivial at first. In finance literature ambiguity is used as a synonym for a particular form of uncertainty where information is missing about the probability of an event. It follows that ambiguity can be resolved with more information. Consider the ambiguity (uncertainty) that prevents investors from forming reliable probabilities about the impacts of climate change policies on un-burnable carbon assets. Once investors have more information they can update beliefs about the probability of policy changes and its impacts. The UN backed Principles for Responsible Investment, representing signatories with over $US 59 trillion in assets under management, has supported several investor initiatives aimed at increasing transparency among governments and companies on climate change.[4] Driving such initiatives is the assumption that ambiguity (uncertainty) can be reduced to risk and then calculated to produce a unique right answer.

Even scholars that recognize ambiguity as distinct from uncertainty are skeptical about its permanence. Outside of finance literature, ambiguity is often defined as the lexical or semantic quality of language. Consider the statement ‘please sit in the apple juice chair.’[5] On its own, this statement is imprecise or ambiguous. Now consider the context. An overnight guest comes downstairs in the morning. The host motions toward the kitchen table. One place setting has apple juice. Once the context is revealed, many would agree that the ambiguity is resolved. Similarly, in law it is suggested that ambiguity in contracts and rules can be resolved by appealing to the underlying intentions of the law that are found in social norms and values. Ambiguity is only temporary.

The ambiguity with which this book is concerned is neither a form of uncertainty, nor is it merely the imprecision of language. The ambiguity with which this book is concerned exists after all possible information and context are revealed, and after standards, norms, rules and agreements are established to deal with potential for multiple interpretations and contradictions. Ambiguity is permanent. This is because the process of resolving ambiguity by appealing to rules, norms and models creates new ambiguities.

Accepting the permanence of ambiguity raises two dilemmas. The first dilemma is how do organizations make good decisions under conditions of ambiguity? The book provides a new analytical frame for explaining how institutional investors presently manage ambiguity (they deny it), and how accepting ambiguity can improve their decision-making. This leads to the second dilemma: How do institutional investors reconcile legitimacy, which requires the demonstration of an unambiguous link between stated goals and action, with their public acknowledgement that there is no right answer? I show that governance is key to reconciling this tension. The denial of ambiguity served financial market participants well in the past, but such denial is becoming more costly to maintain in increasingly complex and integrated global financial markets.

[1] Goldin, I. and Mariathasan, M. (2014) The Butterfly Defect, Princeton University Press, New Jersey.

[2] See Admati, A. and Pfleiderer, P. (1997) Does it All Add Up? ; Rajan, R. (2006) Has Financial Development Made the World Riskier.

[3] Dixon, A. (2014) The Geography of Finance. Oxford University Press.

[4] See http://www.unpri.org/whatsnew/towards-cop-21-update-on-pri-action-on-climate-change.

[5] This is an example provided by Lakoff and Johnson (1980) Metaphors We Live By, University of Chicago Press. The example is used to demonstrate the importance of context to communication and understanding.

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