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Monday, June 7, 1999

FOOL ON THE HILL
An Investment Opinion
by Alex Schay

Certain about Uncertainty

The year was 1975, and a young Edgar Peters was doing some research at the Newark Public library in order to "prepare for the time when [he] might actually have some money to invest." Mr. Peters, a freshly minted college graduate during the period, emerged from school brandishing a degree in mathematics and promptly embraced work as an insurance underwriter in Newark. That fateful day, the 23-year- old relieved the library of its copy of Burton Malkiel's influential tome A Random Walk Down Wall Street. What occurred in the ensuing years is best described by Peters himself:

"First came the decision to learn something about investing, for future use. I sought out a novelty, with a purpose in mind. Next came the surprise of learning that my math background could introduce an entirely different future. My complete change of career and my decision to learn something about investing changed my life and my family's life. My career and my own contributions to the field of investing are unexpected consequences of Dr. Malkiel's decision to write a book about random walk theory."

This story, taken from Edgar E. Peters's latest book, Patterns in the Dark: Understanding Risk and Financial Crisis with Complexity Theory is not merely an autobiographical indulgence. It's a clear illustration of one of the central themes of his book.

The fact that "novelty" can emerge and be absorbed in the form of innovation -- as an unintended consequence of an action taken in a complex system -- means that uncertainty is a natural part of life. While the conclusion that "life is uncertain" may not seem terribly profound, the mathematical proof that uncertainty is a necessary component in the operation of complex processes certainly is. Complexity is the fusion of global structure and local randomness, and in order for innovation and adaptation to occur uncertainty is a requirement. With this assertion, Peters effectively annuls the marriage between risk and uncertainty and forcefully argues that risk can often be lowered when uncertainty is increased.

Burton Malkiel is completely unaware that he changed Peters's life (unless he heard about the book), and because we cannot know all of the possible outcomes of our actions, unexpected events do occur. As Peters notes, the human mind cannot possibly anticipate all of the consequences of any course of action, otherwise our life's decision-making could be satisfied by Bayesian analysis. Probabilities add up to one; that is, they account for 100% of the possibilities. A statistician would state that expected return is the probability weighted average of possible returns, and risk is the bunching of possible returns around an expected return. Virtually all of portfolio theory (really, the application of statistics to finance) is built on this probability/possibility matrix. In the introduction to his book Peters observes:

"We experience true uncertainty when we do not know the probabilities of the possible outcomes because we do not even know what all the possible outcomes are."

The bulk of the book then, is Peters's lucent analysis expounding on the need for uncertainty. Whether he uses the example of genetic algorithms to show how randomness can lead a process to a goal even when the ultimate path is unknown, or if he simply shows how David Bowie's creation of Ziggie Stardust illustrates the integration of two seemingly contrary elements in the creative process (with a nod toward uncertainty as a requirement for stability), Peters's always seems to provide compelling insight into how global structure and local randomness interact.

Ultimately, the book's implications for "global structure" policymakers are more clear than any prescriptions that might be handed down to individual investors acting in an environment of local randomness. However, the discussions regarding various process models and their implications for economic activity are worth the price of admission alone. Interested investors ought to check it out.

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