There is a saying that nature abhors a vacuum. Certainly, humans often abhor uncertainty too — but not always.
Our aversion to uncertainty arises because humans prefer moderation to extremes. We are much more comfortable with an income of $50,000 per year than $25,000 one year and $75,000 the other. The needs and habits we form are best fulfilled when we have steady, predictable resources to fund them.
Banks help us manage risk by letting us safely save when we have more than we need so we can spend later. Insurance companies allow us to pay a little over time to protect us from having to pay a lot in the event of a disaster.
In turn, they earn a profit by providing us greater income certainty than we would otherwise have.
The increased volatility of stock markets has a similar but, perhaps, more subtle effect. When we invest in a stock, we realize we are taking risk. To compensate us, we expect a greater return.
The greater the risk, the greater the return we expect. Alternately, the greater the risk, the less we are willing to pay to purchase the stock.
Financial markets have been volatile for a few years now. Because of this increased uncertainty, stock prices are also depressed. Even though many large companies have returned to profitability, we are unwilling to pay as much because the market appears so precarious.
This uncertainty is because of our concerns over domestic political dysfunction and the European financial crisis. The mere uncertainty has a depressing effect on market prices.
Until uncertainty and risk is reduced, the stock market will not want to rally to a more reasonable valuation proportional to the profits its underlying companies are earning.
The market today has factored into account political dysfunction and a European double-dip recession. More important, though, is that the market is now becoming a bit less volatile.
My sense is that investors are tired of the roller-coaster ride and are settling down a bit. As they do, stock prices rise accordingly.
Our abhorrence of uncertainty also explains why we are fearful of change and are even willing to stop new ideas in their tracks for fear they may demand something different. The more we have to protect and the longer our patterns have endured, the more resistant we are.
This is a vexing but seemingly human condition. For us to change, we need someone to articulate a clear, appealing vision and soothe us with rhetoric that the future will be better.
I don't want to suggest that humans avoid risk and uncertainty at any cost. In fact, some people love risk taking and gambling.
We also enjoy controlled risk — the risk of a roller-coaster, the uncertainties of a horror movie or the twists of a thrilling novel. Perhaps exposing our children to some controlled risks will prepare them for an uncertain world.
Spectator sports, too, afford us controlled uncertainty. We have no opportunity to affect the outcome, but we enjoy the game. My wife finds it odd that I would record a car race and want to watch it without knowing who has already won.
Let me tell you about my trick.
I wanted to see if Danica Patrick could race to the finish at Daytona, but would prefer to watch just the last 30 minutes. So, with 30 minutes left, I asked Natalie to privately flip a coin.
If it comes up heads, or if Danica has been knocked out of the race before the last 30 minutes, she tells me to watch the video later. And if it does not come up heads, but Danica is still in the race, she tells me to watch just the last 30 minutes.
If it is equally likely Danica is in or out with 30 minutes to go, there is a one-quarter chance I watch the last 30 minutes to see if Danica can win, and a three-quarter chance I watch from the beginning, but without knowing if Danica will win or fail to finish.
I enjoy the uncertainty of the race by introducing some uncertainty in not quite knowing. The excitement is preserved for me, without necessarily having to invest six hours into the Daytona 500!
Colin Read is the chair of the Department of Economics and Finance at SUNY Plattsburgh. His tenth book, Great Minds in Finance — the Efficient Market Hypothesists, is coming out this fall. Continue the discussion at www.pressrepublican.com/0216_read.
