Financial Econometrics and Empirical Market Microstructure
Seek Out the New: Harnessing Network Intelligence
Adaptive Stress Testing builds a creative tension between contrarian views of Innovators and the “wisdom of crowds” (Surowiecki 2004). Innovators are contrarians who perceive hidden risks that are not yet accepted by the market. Given that there are potential risks that never materialize, we incorporate the agile sensory intelligence of Early Adopters who are attuned to emerging market themes. Adaptive Stress Testing helps mitigate systemic risk by proactive stress testing while risks are still in potential form, as well as by counter cyclical investment (e. g., leaving crowded theatres early).
As hyper-connected individuals, we can access the entire world’s knowledge with unlimited computational power. No longer bound by slow centralized forecasting and management, we can rapidly adapt to changing conditions. And yet even with the democratization of information, cognitive biases like overconfidence and groupthink hold us back. “We are blinder than we think” notes Tim Harford (2011). Even worse, when faced with uncomfortable truths, most opt for “willful blindness” (Heffernan 2011).
Despite the discomfort, seeking out the new is an evolutionary imperative.
Harford’s Palchinski Principles are a wise guide: “First, seek out new ideas and try new things; second, do [this] on a scale where failure is survivable; third, seek out feedback and learn from your mistakes as you go along” (Harford 2011). We might summarize this as:
1. Seek out new scenarios, and ensure that your stress library represents a diversity of thinking.
2. Seek out new signals emerging from the marketplace, by monitoring outlier activity and super-exponential rates of change.
Polarity management helps manage this process. We first analyze contrarian views at the periphery, and then hone in on signals emerging by Early Adopters who are connected to the broader marketplace.
