Saturday, April 11, 2015

Uncertainty and unknowns - breaking down the process

Project analysis has advanced to include different levels of uncertainty when making decisions. The same approach used for projects can also be applied to asset management. There is a simple decision tree that can provide insights on how to classify and deal with uncertainty.

One of the first choice is associated with events that are foreseeable or known. If event are foreseeable, then a clear decision path can be formed, residual risk can be determined, and the level of complexity can be measured. Buffers and contingencies can be managed based on the level of uncertainty or risk faced. This can be very process driven. This is what we would like decision analysis to look like.

The alternative of unknown unknowns requires a different process. A key problem with finance is real time management when there are unknowns. There is an unknown event and the portfolio manager has to act. There is no way to deal with unknowns through experimentation.  Unknowns in project management can be addressed through two choices. For one path, some form of learning through trial and error or experimentation is conducted. The project manager goes down an unknown path and "figures it out". Adjust plans as you move through time. The other approach for project management is called selectionism. You try multiple path as the same time and then choose what you think is best ex post as the uncertainty is resolved. Asset management does not have the luxury of trying multiple options through different portfolios and then picking the best. Trial and error is not an option. There is no time for trial and error. If we could do that, then the unknown could be measured and it ceases to be an unknown.

Still there is hope in dealing with unknown unknowns. The selectionism is through employing different strategies. Instead of just one strategy, you employ multiple strategies. This form of diversification can be applied when there is different levels of complexity, but may also be appropriate for dealing with unknowns. Diversification is not just across markets but across strategy responses. 

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