Risk Management: Subjectivity vs. Objectivity

By Guest |  10-01-19 | 
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About the Author
Morningstar invites thought leaders from the investment community to share their insights. Views expressed are personal and should not be construed as investment advice.

Jason Voss is writing a multi-part series on real risk management.

In Why context is paramount in risk management, he argued that quantitative data must match qualitatively chosen contexts. In Why preferences matter in risk management he argued that those qualitatively chosen contexts are driven by our preferences, and that risk only exists due to our preferences.

However, lurking in the shadows throughout the above two articles is a tension between subjectivity and objectivity. 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 to be considered, and which preferences to be indulged?

Subjectivity and Objectivity

If you disagree with the idea that preferences are what creates risk it is likely that you believe in an objective notion, or an absolute version, of risk. That might sound like, “We are biologically hardwired to preserve our own life to promulgate our genes. Therefore, anything that threatens that hardwiring, like disease or violence, may objectively be called risk.”

I agree that this is a seductive thought, but I disagree that this is true. After all, underlying this thinking are beliefs, and beliefs are chosen, and therefore subjective. The belief here is likely in a mental model that “we are biologically hardwired to preserve our own life to promulgate our genes.” Yet, people overcome their biology frequently, what else do you call that necktie you are wearing, or those high heels you are wearing?

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 definition of objectivity.

The Double Slit Experiment

Clinton Davisson and Lester Germer in 1923-1927 conducted an experiment popularly referred to as the double-slit experiment 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.

To understand the experiment, we need to first consider the behavior of particles and waves. Let’s consider particles first. Imagine that I have a slit cut into a board, and behind it I have a wall that registers when a ball sent through the slit hits it by continuously illuminating at that spot. I also have a tennis ball gun that I use to fire tennis balls (i.e. particles) toward the slit at random. After firing, say 100 tennis balls, toward the slit what pattern emerges on the white wall behind? The pattern echoes the shape of the single slit.

Now, if I increase the number of slits to two, for example and repeat the experiment, the pattern that emerges on the wall is two stripes immediately behind the two slits. This is logical, right? This simple experiment demonstrates the behavior of particles.

But what happens if instead of particles I send waves through a single slit? I also will see one band on the wall behind the slit. But here is where it begins to get very interesting. When I have more than one slit and send a wave through both slits an interference pattern begins to emerge on the back wall. An interference pattern is the featured image for this article that you can see above. Notice that there are multiple vertical stripes, rather than just two? This is the behavior of waves.

Great! But how the heck does this help to improve my risk management, and my investing results? Bear with me for just several moments more because we are only half way through the double-slit experiment explication. What if we use electrons, that fundamental material particle instead of tennis balls?

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?

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!

This can only be resolved mathematically by assuming that the electron goes through both slits and neither. Double whoa! So, now we know that electrons are actually a wave and not a particle, right? Wrong. Here’s the shocking reason why, and I really cannot emphasize enough just how important this is to understanding, not just the double-slit experiment, not just risk management, but reality itself. Yes, really.

After physicists discovered that individual pieces of matter, electrons, were behaving like waves they decided to set up hyper-sensitive detection equipment to see which of the slits the electron actually goes through by putting a measuring device by one of the slits. What they discovered is that the electron went back to behaving like a particle and so the back wall just had two bands behind the two slits. In other words, when the electron was observed it ceased behaving like a wave, and became a particle! Let me repeat that, when we observe matter it behaves like a particle, and when we do not it is a gigantic wave/probability cloud.

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.

Consequences for Real Risk Management

Above I said that when we observe matter it behaves like a particle, and when we do not it is a gigantic wave/probability cloud. Notice how similar this is to my point about preference being the source of risk. Here is an example. When I prefer to earn a 10% rate of return on an investment, I create my risk of failing to earn 10%. If I have no preference for my rate of return, what is my risk of not earning 10%? Zero. But when I prefer/choose to earn 10%, it is as if I reach into an infinite cloud of possible risks and pluck out the attendant risk of not earning 10% at the exact same time. My subjectivity interacts with the absolute/objective reality and creates the risk. I collapse the probability wave and turn it into a particle.

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.

One Final Note: Overcoming Hard Wiring

As a final note, indiscriminately many in finance throw around the concept of hard-wiring of behavioral biases. This is sheer intellectual laziness, but with real world consequences. Why? How? It is scientifically proven that people are able to overcome their instincts, and in almost every moment of every day. Yet, we would need to invoke hard-wiring in order to preserve the notion of objective and specific risks. This is because we would need to say something like “hardwiring leads to everyone fearing for their physical safety so that they want to protect themselves in order to pro-create and promulgate the survival of their genes.” If this statement were true, then we could preserve the notion of an objective, or universal sense of risk.

But it is not true. We overcome instinct all the time courtesy of our consciousness. I am able through thought to make decisions in defiance of instinct. In fact, learning and neuroplasticity are proof of soft-wiring, not hard-wiring. Therefore, neuroplasticity is also proof of risks being subjective, not objective.

To be clear, I actually do believe in an absolute/objectivity but only in unitary. The definition of absolute means everything and nothing simultaneously…the 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.

This post initially appeared on Jason Voss' blog.

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