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In this series on real risk management<\/em> I have covered the importance of both contexts<\/strong><\/a> and preferences<\/strong><\/a> with regard to investment risk. First, I argued that quantitative data must match qualitatively chosen contexts. Next, I argued that those qualitatively chosen contexts are driven by our preferences, and that risk only exists due to our preferences.<\/p>\n\n\n\n However, lurking in the shadows throughout these two articles is a tension between subjectivity and objectivity. Said more directly, is there such a thing as absolute risk that is true for every person and entity and that is free from the subjectivity of which contexts I want to consider, and which preferences in which to indulge?<\/p>\n\n\n\n <\/p>\n\n\n\n Subjectivity and Objectivity<\/em><\/strong><\/p>\n\n\n\n If you disagree with the idea that preferences are what\ncreates risk it is likely that you believe in an objective notion, or an\nabsolute version, of risk. That might sound like, \u201cWe are biologically\nhardwired to preserve our own life to promulgate our genes. Therefore, anything\nthat threatens that hardwiring, like disease or violence, may objectively be\ncalled risk.\u201d<\/p>\n\n\n\n I agree that this is a seductive thought, but I disagree\nthat this is true. After all, underlying this thinking are beliefs, and beliefs\nare chosen, and therefore subjective. The belief here is likely in a mental\nmodel that \u201cwe are biologically hardwired to preserve our own life to\npromulgate our genes.\u201d Yet, people overcome their biology frequently, what else\ndo you call that necktie you are wearing, or those high heels you are wearing?<\/p>\n\n\n\n Long time readers of my articles know that I am a fan of quantum physics, and of tying consciousness, economics, finance, and investing to the various scientific disciplines. I do this because if we divorce these things from accountability to science, then we are saying science is true except in investing. Frankly, that strikes me as intentional delusion, something to which I do not subscribe. I bring this up because physicists now know that you cannot extricate consciousness (what many refer to as subjectivity) from the Universe. This, of course, is the<\/em> definition of objectivity.<\/p>\n\n\n\n <\/p>\n\n\n\n The Double Slit Experiment<\/em><\/strong><\/p>\n\n\n\n Clinton Davisson and Lester Germer in 1923-1927 conducted an experiment popularly referred to as the double-slit experiment<\/strong><\/a> that proves that consciousness and matter are not separable, but part of a whole. Therefore, it also proves that the divide between subjectivity and objectivity is illusory, too, and for our purposes here, that there is no such thing as objective\/absolute risk.<\/p>\n\n\n\n To understand the experiment, we need to first consider the\nbehavior of particles and waves. Let\u2019s consider particles first. Imagine that I\nhave a slit cut into a board, and behind it I have a wall that registers when a\nball sent through the slit hits it by continuously illuminating at that spot. I\nalso have a tennis ball gun that I use to fire tennis balls (i.e. particles) toward\nthe slit at random. After firing, say 100 tennis balls, toward the slit what\npattern emerges on the white wall behind? The pattern echoes the shape of the\nsingle slit.<\/p>\n\n\n\n Now, if I increase the number of slits to two, for example\nand repeat the experiment, the pattern that emerges on the wall is two stripes\nimmediately behind the two slits. This is logical, right? This simple\nexperiment demonstrates the behavior of particles.<\/p>\n\n\n\n But what happens if instead of particles I send waves through\na single slit? I also will see one band on the wall behind the slit. But here\nis where it begins to get very interesting. When I have more than one slit and\nsend a wave through both slits an interference pattern begins to emerge on the\nback wall. An interference pattern is the featured image for this article that\nyou can see above. Notice that there are multiple vertical stripes, rather than\njust two? This is the behavior of waves.<\/p>\n\n\n\n Great! But how the heck does this help to improve my risk\nmanagement, and my investing results? Bear with me for just several moments\nmore because we are only half way through the double-slit experiment\nexplication. What if we use electrons, that fundamental material particle\ninstead of tennis balls?<\/p>\n\n\n\n When I fire electrons at a single slit, I get a single stripe behind the slit. However, when I fire electrons through two slits an interference pattern begins to emerge. Wait a second, I thought electrons were matter, and so there should have been two stripes on the back wall and not an interference pattern. Weird, right?<\/p>\n\n\n\n <\/p>\n\n\n\n Jason A. Voss, CFA – Your Next Excellent Hire<\/strong><\/a><\/p>\n\n\n\n I would love it if you would receive\nnotification of my new articles \u2013 sign up here<\/a><\/strong> \ud83d\ude42 Don\u2019t forget to\ncomment on the article in the space below. Thanks!<\/p>\n\n\n\n When physicists discovered this, they thought the electrons may have been bouncing off of one another to create the interference pattern. Consequently, they redesigned the experiment to fire a single electron through the two slits, rather than sending them all at once. After firing many electrons in this way, the same vexing interference pattern emerges! It is as if the same electron leaves the gun as a particle, becomes a wave of potentials, goes through both slits, and interferes with itself to hit the wall like a particle. Whoa!<\/p>\n\n\n\n This can only be resolved mathematically by assuming that\nthe electron goes through both slits and<\/em>\nneither. Double whoa! So, now we know that electrons are actually a wave and\nnot a particle, right? Wrong. Here\u2019s the shocking reason why, and I really\ncannot emphasize enough just how important this is to understanding, not just\nthe double-slit experiment, not just risk management, but reality itself. Yes,\nreally.<\/p>\n\n\n\n After physicists discovered that individual pieces of\nmatter, electrons, were behaving like waves they decided to set up hyper-sensitive\ndetection equipment to see which of the slits the electron actually goes\nthrough by putting a measuring device by one of the slits. What they discovered\nis that the electron went back to behaving like a particle and so the back wall\njust had two bands behind the two slits. In other words, when the electron was\nobserved it ceased behaving like a wave, and became a particle! Let me repeat\nthat, when we observe matter it behaves like a particle, and when we do not it\nis a gigantic wave\/probability cloud.<\/p>\n\n\n\n Therefore, scientifically, we cannot say that the concept of objectivity exists because we cannot extract the observer without affecting reality. So, there is no such thing as objectivity, it is an illusion.<\/p>\n\n\n\n <\/p>\n\n\n\n Consequences for Real Risk Management<\/em><\/strong><\/p>\n\n\n\n Above I said that when we observe matter it behaves like a\nparticle, and when we do not it is a gigantic wave\/probability cloud. Notice\nhow similar this is to my point about preference being the source of risk. Here\nis an example. When I prefer to earn a 10% rate of return on an investment, I\ncreate my risk of failing to earn 10%. If I have no preference for my rate of\nreturn, what is my risk of not earning 10%? Zero. But when I prefer\/choose<\/em> to earn 10%, it is as if I\nreach into an infinite cloud of possible risks and pluck out the attendant risk\nof not earning 10% at the exact same time. My subjectivity interacts with the\nabsolute\/objective reality and creates<\/em>\nthe risk. I collapse the probability wave and turn it into a particle.<\/p>\n\n\n\n We can only conclude then that risks are subjective, not objective, and that they are created by our preferences. In short, preferences\/expectations and their probable gap relative to outcome are what we call risk.<\/p>\n\n\n\n <\/p>\n\n\n\n One Final Note: Overcoming Hard Wiring<\/em><\/strong><\/p>\n\n\n\n As a final note, indiscriminately many in finance throw\naround the concept of hard-wiring of behavioral biases. This is sheer intellectual\nlaziness, but with real world consequences. Why? How? It is scientifically\nproven that people are able to overcome their instincts, and in almost every\nmoment of every day. Yet, we would need to invoke hard-wiring in order to preserve\nthe notion of objective and specific risks. This is because we would need to\nsay something like \u201chardwiring leads to everyone fearing for their physical\nsafety so that they want to protect themselves in order to pro-create and\npromulgate the survival of their genes.\u201d If this statement were true, then we\ncould preserve the notion of an objective, or universal sense of risk.<\/p>\n\n\n\n But it is not true. We overcome instinct all the time courtesy\nof our consciousness. I am able through thought to make decisions in defiance\nof instinct. In fact, learning and neuroplasticity are proof of soft-wiring,\nnot hard-wiring. Therefore, neuroplasticity is also proof of risks being\nsubjective, not objective.<\/p>\n\n\n\n To be clear, I actually do believe in an absolute\/objectivity but only in unitary. The definition of absolute means everything and nothing simultaneously\u2026the set of all sets, including the empty set. For convenience, I think of risks as existing up in this infinite probability cloud and that my preference collapses this wave in superposition and creates a particle\/particular risk.<\/p>\n\n\n\n My next article discusses temporality and its importance in real risk management.<\/p>\n\n\n\n <\/p>\n\n\n\n Jason A.\nVoss, CFA – Your Next Excellent Hire<\/a><\/p>\n\n\n\n
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