The Risks That Matter, The Tools We Need

Geeta Aiyer, President and Founder

Reflections on a Financial Journey

The major risks of our time — climate change, pandemics, rising, extreme inequality — are not unexpected, “black swan” events, but rather are well-known, cumulative developments happening all around us. They are interconnected, often mutually exacerbating trends that demand our attention. What are the old habits of financial thinking that prevent us from adequately assessing, preparing for, and acting to avert these risks? And how can we, as thoughtful investors and engaged citizens, reframe our work and make our tools fit for purpose?

What enables our unseeing complicity (doesn’t impact my portfolio, not captured in my spreadsheets, not in my investment time horizon), our studied indifference (not in my job description, suitable for governments, but not investors), our blissful ignorance (seeing no evidence or inconsistencies), and our helpless inaction (unsure how to price this or become engaged)? The US Social Investment Forum’s 2019 report notes the steadily-rising, but still low percentage (26%) of professionally managed assets that consider environmental, social, or governance issues. Why, in other words, is finance disconnected from the growing, potentially irreversible, game-changing risks in the real world?

There are many possible answers: the excessive focus on the short-term, the rise of passive indexation, the dependence on downloadable data, the conviction – especially in the US – that we operate in an efficient market, in which all material risks are already largely priced in; the overwhelming flood of liquidity from central banks rendering the conventional functions of investors irrelevant, further disconnecting real world risks and near-term performance.

The list is long! For now, my focus is on the mundane impediments – the tools, structures, frameworks, and mindsets in Finance that continue to impede us as investors in a rapidly changing world.

A few challenges come to mind: the simplifying focus on averages or central tendencies, rather than outcome distributions, risks and uncertainty; not pricing externalities; ignoring the complexity of the natural and social world; the fickle nature of discount rate assumptions; and importantly, our theoretical underpinnings on the role of finance in society that shape our mindset and lack of agency. I will explore these key challenges in writing over the coming weeks. Today, I will focus on one, namely, how we build scenarios and models.

Our Models

The financial community has long relied on many statistical tools that look to the past in order to model the future, relying on sequences of events and outcomes from a known past. This leads us to derive sophisticated, but bounded predictions of a future that looks like a combination of scenarios from the past! Never has the past been less relevant in predicting the future. As extreme events like superstorm Sandy or a contagious zoonotic disease create disruptions, we label them as outliers, suggesting they are once-in-a-century events many standard deviations away from our “normal” expectations, when in fact these events highlight the changing distribution of interconnected outcomes. The tails are becoming both fatter and longer, as more extreme disasters hit more often. The landscape of risk and opportunity is being re-drawn.

Changing our Models goes hand-in-hand with changing our mindsets. For too long, our inertia has enabled our willful blindness and reckless inaction. We are at a tipping point — we need to redefine our pursuits and reinvent our craft. Our fragile interconnected future demands no less.

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