I’ve taken you on this long trip through risk and uncertainty, not only because I find these ideas both important and intellectually stimulating, but because they set the stage for my discussion of the concerns I hold today regarding our financial system and our society. I recognize that some of these ideas are complex, so let’s summarize the ground we’ve covered so far:
1. Black Swans—extreme and unexpected outcomes—are part of investing, and can’t be predicted in advance.
2. As Karl Popper recognized, not only our market, but science itself, depends not on
observations confirmed by verification, but on wild conjectures sharpened by falsification (proof that the theory is wrong).
3. Frank Knight focused on a critical distinction between risk—which is subject to
measurement—and uncertainty—which is not.
4. Stock market returns, in the short-term, are not normally distributed, but are explained by the fractal patterns discovered by Mandelbrot. We can’t ignore the possibility—indeed, the virtual certainty—that such extreme patterns will persist, and we never know when.
5. Keynes’s insight was to separate stock returns into two elements, enterprise—subject to a reasoned financial analysis and speculation—the madness of crowds—which, he argued, would become increasingly dominant.
6. Bogle (if you will) applied numbers to Keynes’s insight, showing that future investment returns were subject to reasonable expectations, and that even speculative returns tended, over time, to move toward zero.
7. Minsky added a sobering note: the financial economy, focused on speculation, was not separate and distinct from the productive economy, focused on enterprise. Rather, the former would come to overwhelm the latter.
Sunday, October 28, 2007
John Bogle, "Black Monday and Black Swans"
This was posted on Reflections, but I liked it a lot so I'm repeating it here. It gives very in depth coverage on a variety of important issues.