Emerging Markets in an Upside Down World: Challenging Perceptions in Asset Allocation and Investment

Chapter 5

What is Risk?

A Martian falls to Earth¹

Say a Martian, disguised as a human, falls to Earth and becomes a trustee of a pension fund. He is concerned not to invest in markets which are too risky. Unfortunately, he likes abstract models, and rapidly takes to the mathematical beauty of RET and EMH. He sees no reason why people would not have identical preferences expressible via smooth fully differentiable mathematical equations, have perfect information and maximise utility – or at least most of them. He believes in the law of one price and that observed market clearing equilibrium levels must be optimal – traits that perhaps caused problems on his own planet. Perhaps he and his peers there argued that there would always be optimal equilibrium in the long term, but other equilibriums kept getting in the way, so they imposed a different type of equilibrium to take care of the short-term anomalies. Equilibrium, the tendency not to move, in biology is called death: hence the need to move planet.

  He makes two errors in his new job. First, he assumes that there is no Knightian uncertainty, only Knightian risk. Risk can be managed and hedged: he assumes that the more he can analyse something, the more he will understand. As everybody else is doing likewise, the better populated an asset class, the lower the unmanageable risk. Unfortunately there are too many things to analyse and not enough time. Plus, anyway, it’s just a job and this is not even his planet.

  Secondly, he ...