You may be wondering what Albanian prudence is and rightly so, because it’s a term that I just made up. I thought that the Albanians deserved some credit after reading this wonderful passage from Lady Mary Wortley Montagu’s Turkish Embassy Letters (1716-1718):
But of all the religions I have seen, that of the Arnounts1 seems to me the most particular; they are natives of Arnountlich, the ancient Macedonia… These people living between Christians and Mahometans, and not being skilled in controversy, declare, that they are utterly unable to judge which religion is best; but, to be certain of not entirely rejecting the truth, they very prudently follow both. They go to the mosques on Fridays, and to the church on Sunday, saying, for their excuse, that at the day of judgment they are sure of protection from the true prophet; but which that is, they are not able to determine in this world. I believe there is no other race of mankind, who have so modest an opinion of their own capacity.
This idea of being skeptical with respect to one’s own understanding is also a central aspect of Postmodernism, a philosophical current that became hegemonic towards the end of the XXth century, after so many of the dominating ideologies of earlier times (each in its context considered a source of absolute truth) had been either falsified or severely discredited (racial superiority by science, Communism by Stalinism and Maoism, the Enlightened notion of progress by the fact that the Holocaust took place in a society that was considered among the best educated of its time).
Underlying all of this is once again George Box’s aphorism: ”all models are wrong, but some are useful” (here model should be understood as any conceptual framework). Our model-building brains are so attracted by the second part that like to forget the first one, and history is full of examples of how dangerous this can be. Here we will discuss the importance of “Albanian prudence” to counter our mind’s problematic tendencies, along with how this can be brought down to applied fields, particularly to finance.
1. Motivating the role of prudence
1.1. Prudence as one of the four cardinal virtues.
Prudence probably has never been the sexiest element of character. It’s often hard to value the benefits of avoiding trouble as most of the time we cannot accurately run the counterfactual to appreciate how much better off we turn out to be. This is sometimes called preparedness paradox (by preparing for a negative event, we mitigate its consequences and then fail to realise the magnitude of the harm it would have caused had we not taken the relevant measures) and poses a significant hurdle for organizations that are in charge of communicating the need to prepare for future risks (be it pandemics, natural catastrophes or climate change). Another reason behind its lack of appeal is its association with passivity, lack of ambition or limited disposition to explore the unknown.
Despite this deficiency in public relations, prudence has still been generally recognised for its role in enhanced decision making, one of the most notable cases being perhaps the Greco-Roman world, where it was considered one of the four cardinal virtues. The fact that another one of those virtues is courage serves to highlight that prudence is not necessarily at odds with the willingness to face challenges. Rather, the opposite of prudence would be something like recklessness or overconfidence (the hubris that much of Greek mythology warns against).
1.2. Why is prudence a virtue? A heuristic to help manage uncertainty
As previously said, prudence is linked to the idea of being skeptical with respect to our own understanding, which leads to a moderation of our opinions (hence the link to religious tolerance) and actions (hence the confusion with passivity). In more modern terms, prudence is the habit of taking into account the unkown unknowns, that is, having present that sometimes we can’t even imagine what we’ve gotten wrong. Psychologist Jonathan Haidt once asked the audience what it felt like to be wrong, receiving answers he expected like surprise or shame, then he pointed out that that’s what one feels after realising the mistake, before that being wrong feels exactly as good as being right.
1.3. The place of prudence in the modern world
Although prudence does not seem to be a core value of modern western societies, where it’s sometimes perceived as a force opposite to the risk-taking behavior that is necessary for innovation and progress, it’s actually central to perhaps the most relevant philosophical current after WWII: postmodernism. Despite the fact that postmodernism is sometimes thought as a form of radical relativism which gets dangerously close to nihilism, its more interesting proponents are more nuanced2. This is the case of Gayatri Sipvak, which in a debate in 1984, pointed out that the postmodernists are not against commiting to the best theories in any given time in so far they constitute the best available maps for navigating the world, they are just against believing they’re actually true3.
The history of science seems to validate this skeptical attitude towards knowledge. Most of the time we have been believing in wrong theories and it’s likely that now is not an exception. For instance, it’s my (superficial, so I may get corrected on this) understanding that General Relativity and Quantum Mechanics are incompatible which is not very comforting. More generally, any attempt to use experience to prove something true is subject to the problem of induction4 (and even if we step out of experience we have the Münchhausen trilemma), which has lead many in the philosophy of science to be less concerned about absolute truth seeking (positivist verificationism) and more about predictive power or provisional truths (critical rationalism).
Apart from philosophy and science, the importance of being aware of the limitations of our models has also been brought to the fore in applied fields, for instance through the notion of Knightian uncertainty in economics introduced in 1921. A more recent reference is Nassim Taleb’s discussion of black swan events and the ludic fallacy which became especially relevant in financial circles after the 2008 crisis. It may be worth pointing out that what’s underlying these relatively new concepts is none other than the ancient skeptic notion of acatalepsy (the impossibility of total comprehension); perhaps the fact that we are still giving new names to acatalepsy after so many years is a testament to how much we like to forget about basic uncertainty.
2. General applications of prudence
We have presented prudence as a heuristic for dealing with unknown unknowns and we’ve seen that its unappealing character in today’s world is compensated by the relevance of the issue it’s meant to help with (apparently Ignorance management is now even a thing according to Wikipedia). Although the initial idea for these posts came from an attempt to consider the applicability of philosophical concepts in finance, the tool we have here clearly belongs to a much broader field such as decision theory or management science, so we will make a very brief comment on the kinds of applications it can have generally.
There are three main ways of addressing unknown unkowns:
- Prudential estimation and design. This involves trying to take into account what cannot be taken into account, which is by definition impossible. However, good enough approximations can be reached by adding reasonable multipliers to the estimated amount of labor, capital or time a project may require. This is the idea behind the safety factors used in engineering where structures are designed to support loads some multiple higher than the actually expected. More broadly the goal is robustness (or even antifragility5), which can be achieved depending on the context through redundancy, generalization (solutions that work in very varied scenarios) and stability (self-correcting mechanisms).
- Limited scope. The more specific and short the endeavor, the less risk of coming across unexpected obstacles. This is not meant to restrict ambition, but to break big projects full of uncertainty down into smaller more manageable ones; basically keeping short cycles.
- Constant monitorization. Bearing in mind that we are almost surely wrong in some aspect should not be parallysing but lead to periodic reassesments looking out for any cracks in our understanding.
3. Financial applications: prudential asset management against alchemy
Now the above can be used in practically any field, but in finance prudence has one crucial application in the form of a word of caution against “alchemy”. Historically alchemy was the attempt to obtain gold from cheaper metals, here we are using it as a metaphor for the idea of obtaining profits for free. Long discredited since the development of modern chemistry, there’s still room for subtler forms of alchemy in the modern world. Already in the XIII Marco Polo made a lucid observation describing China’s paper money as a form of alchemy: turning wood into gold.
The emperor’s mint then is in this same city of Cambaluc, and the way it is wrought is such that you might say he has the secret of alchemy in perfection, and you would be right.
Of course, monetary history (most notably hyperinflation cases) shows this transformation can be undone at any time6.
In financial markets the most frequent form of alchemy is an attempt to obtain excess returns (returns above the market rate) without incurring in additional risk. This is not to say that arbitrage (the obtention of riskless profits) is imposible, actually, the history of certain (exceptionally sophisticated) funds such as Reinassance Technologies shows it isn’t. However, even these top world participants have problems when trying to scale their methodologies, proving that the room for arbitrage is quite limited.
The market is too big and too many eyes are watching for any sizeable amount of money to be left on the table without anyone grabbing it immediately. The competition is fierce and the amount of human and technological resources devoted to get there first is easy to underestimate. In fact, the misattribution of excess returns to arbitrage instead of excess risk bearing is a recurrent theme behind the failure of many large financial institutions. The greatest recent example is the Global Financial Crisis of 2008, where many banks discovered too late that their profits had been coming in along with substantial amounts of risk that they were not ready to face.
As a concrete instance of this we can consider the case of UBS, which had to be bailed out by the SNB due to unsustainable losses resulting from unrestricted CDO Super Senior (“Super Senior” meaning with the highest credit rating) positions. Positions were unrestricted because they were profitable and they thought they were risk free. Indeed the high credit rating guaranteed minimal risk of default which was in addition partially or fully hedged; the issue was with the liquidity risk that these positions implied which had gone unnoticed.
In contrast, the prudent approach is skeptical with respect to the possibility of conducting real arbitrage (truly risk free) and would limit exposure to such appealing trades. This is also the rationale behind placing weight restrictions on quantitatively designed portfolios. Such practice is almost surely leading to suboptimal performance under the framework (the model and the historical data) in which the portfolio was designed, but it is precisely so because it is born out of a healthy mistrust of any framework. Similarly, the setting of fixed percentage stoplosses (i.e., always 5% independent on model estimations) represents a form of prudential risk management that is based on the possibility of the model underlying the investment methodology being wrong.
In essence, when it comes to financial markets the prudent answer to the question ‘is money being left on the table?’ is practically always ‘no’ (unless that table is very small or you are exceptionally quick). In finance, if a story sounds to good to be true, it’s probably not.
A final word can be said regarding passive investing. It’s also based on a model of the world that is at best a good approximation. The fact that it’s so simple with respect to the alternatives makes it more robust against failing assumptions, but there’s a risk nonetheless so it makes sense to conduct some level of periodic monitorization to confirm that results remain within expected values.
Conclusion
To sum up, prudence constitutes a heuristic for taking into account the unknown unknowns. This is achieved by being skeptical with respect to our own beliefs, an inherently dialectical posture that has been championed by postmodernists among many other thinkers and practitioners. The idea is to retain the ability to commit to our models and benefit from the truth that’s in them, while remaining ready to adjust and adapt when their shortcomings become relevant.
Footnotes
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Arnaut is a Turkish ethnonym used to denote Albanians. During the 18th century Albania was under Ottoman rule. ↩
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For the uninteresting/dark side of postmodernism the Sokal hoax is a good place to start. ↩
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If you listen to the debate (which I would recommend) notice how there are three views more or less consistent with our three sources of inspiration for this trilogy of dialectical finance. We have what looks like an enlightened rationalist (idealism), a Marxist (materialism) and a postmodernist. Thesis, antithesis and synthesis. Interestingly, the synthetic nature of postmodernism can be appreciated in the debate too, as John Dunn and Ronald Aronson seem to be on the same team at times, despite having diametrically opposite views; i.e., the advent of postmodernism reveals the underlying common element in idealism and materialism (namely, their taste for grand theory). ↩
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Originally stated by Hume it refers that any theory about future events based on past experience is liable to the failure of uniformity, that is, to the possibility that the system changes its behavior. E.g., the laws of the universe could change at any point, as it’s nowhere written that they should remain constant; which is not to say that uniformity is a extremely useful (necessary) assumption and also quite a reasonable one considering Occam’s razor. Anyway, perhaps a more graphical description (and hence easier to remember) of the problem is provided by Bertrand Russell’s:
↩Domestic animals expect food when they see the person who usually feeds them. We know that all these rather crude expectations of uniformity are liable to be misleading. The man who has fed the chicken every day throughout its life at last wrings its neck instead, showing that more refined views as to the uniformity of nature would have been useful to the chicken.
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One could argue that in the case of antifragility (the capability to benefit from stressors) there’s no need for concern, and similarly in a context of risk seeking preferences. Still, these conditions only hold locally, there’s always an amount of stress or risk that becomes too much for anyone/anything to handle, so it’s important to know the boundaries and that brings us back to square one. ↩
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This is not an argument in favor of gold, which is not free from inflationary episodes either, as was shown in Egypt during Musa I of Mali’s pilgrimage to Mecca or in Spain during the American conquest. Certainly gold is much more robust to inflationary pressures than other forms of money, but this does not come for free and whether the trade-off is worth accepting is often a matter of context. ↩