Harness risk with corresponding adjustments in time and wealth
The price of a financial product obviously does not remain stable over time. It changes constantly affected by the degree of investors�™ reactions to economic and market conditions. Therefore increased volatility indicates the risk of invested wealth over time. What is very important is that there is always a strong relationship between the three variables: Time, Wealth, and Risk. [T.W.R]. In order to find the way that they connected together, variable of risk in terms of human behavior has to be investigated.
To examine the level of Risk for any financial product, the common paths that have to be followed are: Investigation of the behavior of its historical prices using quantitative indicators and investigation of the fundamentals of the underlying financial product. For example, in order to examine the level of risk on EUR/USD, we investigate its price behavior as well as the market conditions in US and EUROZONE area. Therefore if an investor currently holds a long position, and we assume that there has been an accumulation in the EUR/USD price, risk may increase if a price breaks an important support level whereas it may decrease if price breaks a significant resistance level. Similarly – based on fundamental analysis- risk may increase if unemployment in EUROZONE area increases, while risk may decrease if consumer�™s confidence in US decreases. In both cases, the level of risk stems from social behaviour.
As the Classical Greek philosopher Plato, who is the founder of the Academy in Athens (the first institution of higher learning in the Western world) reminds us, human behavior stems from three main sources: desire, emotion, and knowledge. Consequently, applying the above in the context of EUR/USD, a decline in EUR/USD prices below technical support levels may reduce investors�™ desire to remain in long position. Also, the investor may be under significant emotional pressure since based on theoretical knowledge he knows that when price breaks a significant support level, there is a high probability for further retreat. Conversely, if in Eurozone countries�™ Gross Domestic Product improves, the risk for the same investor who holds a long position on EUR/USD will decrease because the fear related to the economic instability in Eurozone area will decrease.
This is how risk fluctuates when examined in terms of human�™s reactions. It must be noted however that it is difficult to estimate the level of risk generated in any of the previous scenarios. The reason is that we will never learn how to calculate the reactions of desire, emotion, and knowledge for humans.
What we could do in order to manage risk related to humans reactions, is to use the two remaining variables with which the variable risk is strongly correlated; these variables as stated above are Time and Wealth. The mathematical relationship between the variables can be described as follows;
According to this equation if risk changes, then the remaining variables must readjust accordingly as follows.
In the follow chart we see how variables of time and wealth adjusted whenever there are changes in Risk.
The crucial point is to follow the paths, as we can see it in the above chart, in such a manner so as to create conditions for optimum balance equilibrium between the variables. The level of risk changes when a change in human behavior occurs. Inevitably variables wealth and time should adapt accordingly. For instance, the risk will increase, if a stock market sentiment of fear increases. Therefore the time of exposure should be adapted as well as the number of shares on portfolios that invest in stock exchange. Corresponding adjustments should be made if the risk decreases because of possible increased investor expectations.
From a macroeconomic policy perspective, it is important for policy makers to follow the above rule of three variables. Thus if there is an improvement of the economic conditions in response to the euphoria that can dominate the community, the risk is in the low levels. For this reason governments should seek increased wealth for a long time. Instead, if there is deterioration in economic conditions that respond to fears that can dominate the community, the risk is in the higher levels, and therefore governments should pursue reduction of wealth – for a short time period, though.
In the context of the recent European crisis this rule has not been applied. In the southern European countries risks in recent years had significantly increased. The wealth of society has adapted negatively, however it remains unknown how much time these countries will need for the necessary adjustments. If the adjustments require more time, policy makers have to either reduce wealth or reduce the level of risk. However further reduction of wealth may have unpredictable consequences to society because fear will further increase, desires will be reduced and knowledge will be limited. Consequently, the current situation in north European countries requires an immediate reduction on time adjustments. That means policy makers must make necessary adjustments in the economy in a very short period. Otherwise societies may react unpredictably and the consequences can be devastating.
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