We underestimate the risk associated with investment decisions, according to new research by Dr Ole Peters from Imperial College London, by underestimating fluctuation in the risk of investments over time.
Investors know that there are myriad possibilities for how a financial market might develop. Before making an investment, they try to capture these possibilities in a single number to represent likely market performance. They can do this in one of two ways: 'ensemble averaging,' which runs possible scenarios in parallel, or 'time averaging,' which runs scenarios in sequence.
This new study shows that, in the investment world, the differences in the results from these two approaches are critical: time averaging inherently incorporates a measure of risk, but ensemble averaging does not.
This means that ensemble averaging consistently undervalues risk by underestimating the effects of time on investments and overestimating the degree of choice that investors have. It also encourages excessive leveraging of investments, which itself accentuates fluctuations in the market, increases market volatility, and imparts a negative drift in the market that helps drive investors into negative equity.
"In the investment world, ensemble and time averages give different results, with ensemble averages systemically ignoring the effects of fluctuations," said Dr Ole Peters, author of the study from the Department of Mathematics and Grantham Institute for Climate Change at Imperial College London. "If investors routinely used time averages, it would help to avoid scenarios such as the excessive leveraging of investments that contributes to market instability and the likelihood of market collapse."
"Too often, investors behave as if they had access to different scenarios playing out in parallel universes whose outcomes they combine and average," explained Dr Peters. "This misleadingly encourages them to think they have more choice and face less risk than is actually the case. In reality, we are stuck in one universe and, as a consequence, time has a bigger effect on investment risk than we imagine."
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