The difference between risk and uncertainty

The FAUC assessment

The difference between risk and uncertainty

The world is complex and the future uncertain. What does that mean for the existing models on which we base our expectations? For Prof. Lex Hoogduin, professor of complexity and uncertainty in financial markets and financial institutions and Chairman of LCH Clearnet, it was a reason to set up the Global Complexity Network (GloComNet), an open platform focusing on how to deal effectively with ‘complexity and uncertainty’. Zanders joined last year and together we developed the Framework for Acting under Uncertainty and Complexity (FAUC).

How did GloComNet come into being?

Hoogduin: “Since 2013, I’ve been working as a professor in dealing with complexity and uncertainty. We decided to set up a network in order to spread awareness about this subject because one day a week was not enough for our research. The network makes it easier for people to do research. Moreover you can help companies and organizations to deal effectively with complexity and uncertainty. We see that a lot of organizations struggle with this. They keep losing grasp of the material. This often has to do with unexpected developments, usually in the fields of globalization and digitization. The traditional methods which were used to come to grips with your surroundings already had their limits. However, due to all these changes, these have emerged even stronger. You won’t get there on traditional techniques alone.”

Do complexity and uncertainty deal mainly with insight into the future?

Hoogduin: “The point is that the future is fundamentally uncertain. You can’t predict it, but you can surely imagine it. Look especially at new possibilities and threats to see if the image you had still fits or if you need to do some adjusting. It’s important to know what you want to achieve, but not by making a detailed plan for the future.”

Naber: “You can compare it to a soccer game. During the first minutes of a game, you can’t say for sure what’s going to happen in the 30th minute. But you can have an idea about how the game will end. And then, the trick is to create a team that is able to adapt to any situation. That team must be resilient and have the perseverance to win. So that’s how you’d have to arrange your organization.”

“It measures the fitness level of the team”

De Vries: “That’s what’s so great about the FAUC assessment (see referred text) which we developed. Keeping to the same imagery: it measures the fitness level of the team. Your organization must be ‘fit’ in order to be able to respond to opportunities and threats.”

What is the role of GloComNet and FAUC assessment in all this?

Hoogduin: “We try to equip people, companies and governments in such a way so they can flourish in an environment in which you don’t know your competition’s next move or you don’t know which direction politics are going.”

Zanders joined GloComNet last year. How did that come about?

De Vries: “With such a collaboration, we are able to further broaden and strengthen our knowledge and services. We can make calculations long after the decimal point, but we need to make sure everything before the decimal point is good. The world is getting more and more complex, especially due to technological innovations, the ever-growing world population and social media.”

Naber: “As an econometrician, it annoys me that we sometimes think with a few concise metrics we can calculate exactly how the world will be in a couple of years. Which companies are successful? The companies that have created a culture in which they react very quickly. The following is also a trend we see: big companies are becoming smaller; taking a step back in order to be more agile. A nice example: how are you going to hedge BMW’s decision to produce larger models in the U.S.? Nobody knows what the dollar will be doing in ten years’ time, but if it’s extremely cheap, they will immediately see a huge automobile market. Therefore, instead of following a hedging strategy, they have a strategy in which they’ve built a certain amount of resilience, no matter what. And that’s what I see in the FAUC assessment.”

What value does Zanders add to GloComNet?

Lex Hoogduin FAUCHoogduin: “We aren’t saying: throw all the existing techniques away. We are saying: use them together with other ideas. For us, it’s very appealing to work together with a party who does just that; moreover one who has a lot of smart people who help us further develop our thinking. We need Zanders to fine-tune the many interesting ideas and turn them into concrete products. The FAUC assessment would not exist if it weren’t for our collaboration.”

Is man able to solve very complex problems on his own?

Hoogduin: “Man’s knowledge and processing capabilities are limited and he makes mistakes. Our approach doesn’t suggest you should stop making models. The distinction between a good model and a good rule of thumb is less clear than we think. They are instruments that have been designed to have a grip on the future. Only they are not perfect and we need to recognize that. Therefore you shouldn’t only work with models, but also take other things into consideration.

The concept of humanity which lies within FAUC, is that homo agens, man as an acting being, is imperfect and must make choices in a complex, uncertain environment. He is aware of that, therefore making him extremely alert in order to adjust when necessary.

“The distinction between a good model and a good rule of thumb is less clear than we think”

The more pretentious model user is the homo economicus, who acts by using the probability theory in order to solve a problem. The FAUC is based on two very fundamental insights: whatever happens, you’re going to be surprised. And: you don’t have all the knowledge and information in order to make a decision that doesn’t need any adjusting.”

So, the FAUC can be applied to a very wide area?

Hoogduin: “In the book Human Action Ludwig von Mises describes the homo agens from a humanities point of view. What has made civilization possible, how societies have developed and how a kind of order has arisen despite us knowing very little. Ironically development means you know less, but can do more. You need to know very little in order to benefit from the expertise of others.”

This sounds like a quantified psychological theory.

Hoogduin: “The basis for the theory is that there are limits to what you can quantify. People can imagine several different futures and then compare them. You have an ordinal scale allowing for rank. However, you don’t have a cardinal scale so you can’t measure it and express it numerically.”

Does objectivity exist then?

Hoogduin: “A number of issues is evident. That the future is uncertain is a logical certainty. That’s unavoidable since we have the capacity to learn and innovate. Another given is that people are very different. The theory states that an order is created based on those assumptions. Economics or social science is more than empirical logic in this view. Valuations are fundamentally subjective in this theory.”

Is complexity created as a result of the subjectivity?

Hoogduin: “No, the complexity comes from the heterogeneity. In the standard theory, representative subjects are often worked with. However, complexity comes from the undisputed fact that people differ greatly when it comes to preferences, abilities and knowledge. And that people interact with each other. If people are different, there’s an advantage of exchange; therefore, a basis for developing markets.

“The system has become more uniform and thus more vulnerable”

This requires basic things such as language, a legal system and money. So you have a civilization, a market economy and a social system. And such a system is complex, because it is a heterogeneous collection, with interacting elements that react to their environment. Complexity exists from the idea that people are different. That differs from the standard economy in which the homo economicus exhibits stable behavior. Everyone has their own environment and everyone is connected because there are rules, and that explains the patterns.

Another important point is that it’s a human complex system. People have consciousness and intentions. That means that we as humans have
limitations to understanding ourselves and our intentions. The theory is largely a logical system with a bit of empiricism which you can apply to practical issues. Unlike a standard theory, with the intention to predict using a model, this is essentially applied history, in which the intentions of the players are used.”

Regulation leans towards homogeneity. Is that due to the complexity as a result of heterogeneity?

Hoogduin: “Quite the reverse; regulations treat different things in the same manner and thereby affect the operation of the system. More concretely: in recent decades, the diversity in the financial system has decreased; it’s become more of the same. What keeps an organization healthy is showing resilience.
In other words, able to handle unexpected hits. The system has become more uniform and thus more vulnerable. If conditions change, it has the same effect on everyone. Dutch institutional investors had an important role in the resilience of the system. By looking further to the future, they were able to handle hits quickly.

“Something unexpected always happens”

Partly due to monitoring, institutional investors are increasingly being treated as if they were banks. As a result, their shock absorption has disappeared. Benchmarking and providing information by a limited number of rating agencies has the same effect. A homogeneous system is not resilient and undermines the efficiency of financial markets.”

Are benchmarks therefore dangerous for markets?

Hoogduin: “Yes, they make the system vulnerable. Imagine a world in which all financial institutions are identical in their preferences, the information they use and as a result, the portfolio they all have. As long as it’s based on what has actually happened, then everything is fine. But something unexpected always happens. Everyone adjusts their portfolio and who is now the competition? The central bank. The only thing that is important is what the central bank will do. Then you have a perverse financial system in which the markets don’t work.”

In monitoring, is there then a realization that the homogeneity isn’t working?

Hoogduin: “Monitoring is very risk-oriented and relatively uniform. The argument is that banks must hold capital as a buffer against risk. There is no theoretical foundation for this. Because then you could insure everything if the probabilities are stable. Buffers are necessary in order to remain resilient to contingent events.”

FAUC assessment
Social complexity and uncertainty increasingly impact the world. In addition to traditional assessment techniques, organizations require a new approach to remain competitive. The FAUC helps organizations to deal with complexity and uncertainty effectively. The FAUC assessment diagnoses the health of the organization based on five key capacities: entrepreneurship, alertness, adaptability, resilience and creativity. It provides clear insights into the strengths and weaknesses of an organization, using a combination of workshops and a web-based questionnaire. The resulting report delivers recommendations as a guideline for action.

MORE INFORMATION CAN BE FOUND IN THE FAUCTM BROCHURE.