Four Keys to Understanding Uncertainty

Barry Ritholtz has an interesting piece on uncertainty:

From the investor’s perspective, markets require uncertainty to function. Indeed, they thrive on doubt, imperfect information and a lack of consensus. Uncertainty drives the market’s price-discovery mechanism. Investing requires differences of opinion, for when there is broad agreement about an asset’s fair value, trading volume falls.

Without uncertainty, who would take the opposite side of your trade?

People don’t take the opposite side of your position because they are more or less certain about the future. It has nothing to do with uncertainty. It is all about differences in expectations, time frame of operation and market approach.

My take on uncertainty:

1) Uncertainty is always subjective. It is a state of mind that is derived from a mix of objective data, emotions and personal experience. To say that the market is always equally uncertain is to say that mood is always the same. It is not. It constantly changes.

If the perceived uncertainty is always the same, earnings reports would not have such huge impact on prices. We all know that this is not the case. In many cases, earnings reports provide new data that changes market expectations and therefore prices. Options premium is higher before earnings exactly because uncertainty is higher.

2) Uncertainty has become a synonym for bad mood in our everyday life.

The future is always uncertain, but our perceptions of the future vary. And perceptions define actions. Actions (supply and demand) define prices. Somehow uncertainty is used with a highly negative connotation in our everyday life. It is a game of words. Just like the weather people always say that there is a 30% chance of rain and never that there is 70% chance of sun.

3) Uncertainty is basically another word for market sentiment. High levels of perceived uncertainty (bad mood) and high levels of perceived certainty (good mood) have historically been good contrarian indicators, IF your investing horizon is long enough.

4) There are different types of uncertainty.

There is an economic uncertainty. Uncertainty leads to a decline in economic activity. Less people are hired. Old machines and software licences are used longer. Investments are cut. This is what it has been happening in Europe for 2 years.

There is market uncertainty that impacts volatility. When correlation is close to 1.0 (another way to say that stocks move together disregarding of their individual characteristics), uncertainty is perceived as high. It leads to choppy environment that market timers prefer to sit out in order to preserve monetary and mental capital. Perceptions define reality.