Don’t worry about uncertainty.
For retail investors, advice doesn’t come more counterintuitive than this. Traditional risk assessment focuses on predictability. The more certainty, the better.
But according to research from Northwestern Professor of Management Ian Dew-Becker and Yale Professors of Management Stefano Giglio and Bryan Kelly, that’s not how the professionals think. The pros aren’t looking for uncertainty. They worry about volatility, and the difference is a big deal. Per Yale Insights:
“Uncertainty in the economy—triggered, say, by a change in government, a diplomatic conflict, or a turn of the business cycle—is usually considered bad news for people who want to invest their money…. [But] investors are more concerned about actual volatility in prices than periods of high uncertainty.”
In fact, according to research from Dew-Becker and his colleagues, “investors historically have viewed periods of high uncertainty as being good news” as it can sometimes come during “periods of high innovation and growth, which could cause uncertainty shocks to earn positive premia.”
In no market is that currently more evident than cryptocurrency.
Key Takeaways:
- Uncertainty is the degree of likelihood that your investment may change in value.
- Volatility is the degree to which your investment may change in value.
- According to research out of Northwestern and Yale, investors protect their investments against volatility, not uncertainty.
Despite a market cap worth hundreds of billions of dollars and a flagship investment which has crested at over $20,000 per unit, uncertainty continues to dominate cryptocurrency investment. This is particularly true as regulators around the world decide how to handle bitcoin and its progeny. Changes to the law can cause wild swings in asset value, but that can create as much value as it destroys.
The best way to invest around that unknown is to understand the difference between the risk of change and change of risk. For the professionals, this kind of uncertainty/volatility risk analysis is key.
First: Distinguish Uncertainty From Volatility
Uncertainty, otherwise known as “implied volatility,” is critically different from volatility, otherwise known as “realized volatility.”
In an uncertain market, investors measure an asset’s likelihood to change. A 10 percent measure of uncertainty, essentially, argues that there is a 10 percent chance that the value of this asset will fluctuate.
Volatility, on the other hand, measures the degree of change investors expect from this asset. A 10 percent measure of volatility argues that the asset is likely to change in value by plus-or-minus 10 percent. Per Yale Insights:
“Consider ten cities that all have a 1 percent risk of fire. One could purchase insurance that protects against an inferno, so the insured person is paid in case of a fire. Or an individual might opt for insurance that protects against an increased risk of fire—so if the risk spikes from 1 percent to 50 percent, they receive payment from the insurance company. While the former reflects worry about a fire itself, the latter option—purchasing insurance against an increased incendiary risk—stems from a fear of uncertainty. “
Understanding this distinction is crucial in a rapidly changing market.
To consider a bitcoin investment against future regulation, investors may analyze the impact of SEC action in the cryptocurrency space in two distinct categories. First, there is uncertainty: What is the likelihood that future regulation will change the value of bitcoin? Second, there is volatility: By how much will future regulation change the value of bitcoin?
Then: Discard Uncertainty, Evaluate Volatility
Then disregard uncertainty.
Or as Dew-Becker and his colleagues put it in more technical terms:
“First, for markets associated with macroeconomic uncertainty – futures with nonfinancial underlyings – shocks to uncertainty carry a positive risk premium. That fact implies that marginal utility covaries negatively with uncertainty in those markets: uncertainty is high in good times. Second, for financial underlyings, uncertainty has a risk premium that is not significantly different from zero, indicating that it has no average correlation with marginal utility. Third, for both financial and nonfinancial underlyings, realized volatility – a measure of the magnitude of realized movements in underlying prices – carries a negative premium.
So while forward-looking uncertainty carries a positive or zero premium, surprise jumps in prices robustly earn negative premia.”
Unpacking that, what the Yale/Northwestern research found is that professional investors either ignore or are more drawn to markets with high risks of change. They theorized that the reason is the potential gains from instability.
A market with high uncertainty can change, but it can change in many directions. Highly uncertain markets typically reflect changes which can create value as much as destroy it. New technologies, new business formation, and new regulatory schemes are all high-disruption events, but ones which often leave the market better off (even if the fate of individual participants cannot be known).
High volatility events, however, spook investors. They pay extra to protect against larger potential losses or will take smaller losses to hedge their portfolio, even if they’re less worried about the likelihood of that loss. From the insurance example above, a modern investor would not pay to protect against an increased risk of fire. However, he or she would pay to protect against the risk of an inferno.
For our bitcoin example, this means disregarding whether future regulation will change the cryptocurrency marketplace. Change may create value as easily as it could destroy it, and will likely create overall value in the long run. Instead, focus on the potential magnitude of any change.
You’re not concerned about a 10 percent risk that your investment will change. You’re worried about the risk that it will change by 10 percent.
Finally: Price Volatility Into Your Investments
With your risks sorted and prioritized, what next?
Now you price this into your investments.
Investing around risk is one of the core skills of a long-term investor, particularly in a market as unstable as cryptocurrency. Entire fortunes can be made around your ability to hedge against a bad bet.
Here, take your measure of volatility and quantify it. Put a number to how much you think bitcoin will change. Do you think it will change by “a lot” while you hold your tokens? Does that mean 15 percent, 40 percent or 75 percent?
Despite all the research you will do to reach this conclusion, to a certain degree it will have to rely on a judgment call. Turning a prediction into numbers is not a science. Properly done, it should rely heavily on numbers. Trend lines, past pricing indicators, current volatility, these should all play a role in your final decision, but ultimately what you think will happen next…well, no spreadsheet can give you the right answer.
If it could, Excel would have made millionaires of everyone.
Take that final risk assessment, your quantified measure of volatility, and invest around it. If you anticipate a 15 percent change in value, for example, then take that same amount of your capital and move it into a short position on the bitcoin futures market. You have now hedged your bets.
Or assess your investment at a 15 percent total loss and purchase your bitcoin according to that valuation. (How would you invest if doing so led to a 15 percent total loss?) Here, you have invested against loss.
This is, of course, an absurdly simple primer for investing against risk in the marketplace. You will be in a better position to protect yourself against that risk, however, now that you better understand a new way to analyze it.
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