Managing Portfolio Risk: The Importance of Thinking Like an Economist -Elements of Portfolio Management Decisions Under Uncertainty
Portfolio management is a complex task that requires multiple personas, including an economist, a behavioral scientist, an enterprise architect, and a financial analyst. Each of these personas requires different ways of thinking about and analyzing data, as well as consideration of the multiple factors that may impact the portfolio’s performance. However, one thing that remains constant across all of these roles is the importance of uncertainty.
Uncertainty is a critical component of economic theory and is essential to consider when managing a portfolio. It refers to the limited knowledge we have about the future, caused by the gap between the available and required knowledge to make the best decisions. Ignoring uncertainty in decision-making is equivalent to ignoring reality, and it can lead to poor outcomes.
To overcome the challenges of uncertainty, practitioners must recognize that all variables, analyses, and decisions involving uncertainties can be represented probabilistically. This means that, instead of trying to predict the future with certainty, practitioners should use statistical models to estimate the likelihood of different outcomes. This approach can help mitigate the risks associated with uncertainty and improve the accuracy of portfolio management decisions.
In the field of project portfolio management, the concept of risk is prevalent. This is because all human efforts are constrained by limited and uncertain knowledge. Practitioners are often unsure about external future events, governance, and future opportunities, as well as how people are likely to behave. As a result, decision-makers must balance recognized opportunities and production demand in environments where they are unsure about their own situations and the available opportunities.
Economists have always recognized the influence of inadequate information and risk on portfolio management decisions. Economic theories provide a rigorous foundation for the analysis of decision-making, available opportunities, and production demand balance. However, the challenge for portfolio management practitioners is that economic concepts are not always presented in a comprehensible manner. Therefore, it is important to have a solid understanding of economic principles and theories to effectively manage a portfolio.
The economics of uncertainty plays a crucial role in helping decision-makers manage uncertainty and risk. To make decisions under uncertainty, decision-makers must specify:
• A set of actions and states
• A consequence function showing outcomes
• A probability function expressing beliefs about the likelihood of different states occurring
• A utility function measuring the desirability of different consequences
Ultimately, decision-makers must use an expected utility rule to integrate all of these elements and decide on the best action.
Table 1 Decisions under uncertainty components, variables, and functions
|Components||Variables and Functions|
|A set of actions||(Xi select, plan, manage…)|
|A set of states||(Sj chose, reject delay, increase, decrease…)|
|A consequence function||C(X,S) showing outcomes|
|A probability function||P(S) expressing the belief that state S will occur|
|A utility function||v(c) measuring the desirability of different consequences|
One key distinction in economics is between the economics of uncertainty, and the economics of information. In the former, organizations adapt to their limited information by choosing the best available action. In the latter, organizations take informational actions to generate or acquire new knowledge before making a final decision. This distinction is important because it helps decision-makers understand the trade-offs between taking action based on limited information, and taking the time to acquire new knowledge.
Another important distinction is between market uncertainty and event uncertainty. In the former, everyone is fully certain about their own preferences regarding opportunities. In the latter, there is uncertainty about the events themselves. This distinction is important because it helps decision-makers understand the sources of uncertainty and tailor their risk management strategies accordingly.
When making decisions under uncertainty, decision-makers have two broad options: they can take “listed” actions or they can take “informational” actions. Listed actions are pre-determined and require no additional information or analysis. These actions are typically taken in situations where the decision-maker has a high degree of confidence in the outcome of their actions, or where the cost of acquiring additional information outweighs the potential benefit. In contrast, informational actions are taken to improve the decision-maker’s knowledge before making a final decision. These actions may involve acquiring additional information through research or analysis, or they may involve testing different scenarios through experimentation or simulation.
In conclusion, economists play an important role in helping decision-makers manage uncertainty and risk. By unifying important concepts and providing guidance on decision-making under uncertainty, economists can help decision-makers make informed choices and mitigate the risks associated with uncertainty.
For Further Reading – “Uncertainty in Economics”, Peter Diamond, Michael Rothschild, Academic Press, 1989