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Binary notes – The more meaningful questions in investment rarely have yes/no answers

27/01/2015

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

By this point in January, even those of you who do not share The Value Perspective’s consistent and year-round dislike of financial predictions may well be experiencing a degree of forecast fatigue. If so, we apologise for revisiting the subject one more time but just how many of the predictions you have seen in the last month or so have been ‘binary’ in nature rather than covering a variety of possibilities?

Binary predictions are so called because, as Nassim Taleb and Philip Tetlock explain in a 2013 paper they co-authored on the subject, they “are about well-defined discrete events, with yes/no types of answers, such as whether a person will win an election … or a team will win a contest. We call them binary because the outcome is either 0 (the event does not take place) or 1 (the event took place).”
As Taleb and Tetlock acknowledge, this sort of framework lends itself well enough to questions of sport, say, but rather less so to investment. Yes, whether a market goes up or down or a company makes a profit or a loss may be binary questions but by far the more interesting – and practical – considerations are how much a market rises or falls or the extent of a company’s profit or loss.

Here on The Value Perspective, in other words, we would say the crucial question is not whether an investment goes up or down but by how much – yet that is the sort of question that tends not to be addressed in turn-of-the-year predictions. No doubt plenty of forecasters will have suggested the price of oil would fall over the course of 2014 but how many actually ventured the view it would halve?

Offering an example of their own, which they source to an issue of Bloomberg Magazine from March 2008, Taleb and Tetlock note how Morgan Stanley correctly predicted the onset of the subprime crisis – the only snag being “they had a binary hedge and ended up losing billions as the crisis ended up much deeper than predicted”.

Taleb underlines how an investment’s direction of travel may be less relevant than one might imagine in his book Fooled by randomness. In it, a trader is asked whether he thinks a particular market will go up or down and confidently replies “up”. His questioner then grows angry when he learns that the trader was actually short the market – in other words, he would benefit from the market going down.

Taleb continues: “The trader had a difficulty conveying the idea that someone could hold the belief that the market had a higher probability of going up, but that, should it go down, it would go down a lot. So the rational response was to be short.” Investors need to consider the potential pay-offs of different scenarios and, ideally, identify ‘asymmetrical’ bets that can magnify the upside or limit the downside.

The good news is that, as investors, we can acknowledge financial and economic matters are rarely binary in nature and indeed that outcomes can be orders of magnitude different. The bad news, however, is that, as human beings, our brains are not wired to think in terms of varying pay-offs – what Taleb and Tetlock call the “vanilla”.

“The binaries are mathematically tractable, while the vanilla are much less so,” they observe. “Hedging vanilla exposures with binary bets can be disastrous -- and because of the human tendency to engage in attribute substitution” – think ‘mental shortcuts’ – “when confronted by difficult questions, decision-makers and researchers often confuse the vanilla for the binary.” Forecasters too.

Author

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth. 

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