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March 4, 2012

In some things, humans abhor uncertainty

There is a saying that nature abhors a vacuum. Certainly, humans often abhor uncertainty too — but not always.

Our aversion to uncertainty arises because humans prefer moderation to extremes. We are much more comfortable with an income of $50,000 per year than $25,000 one year and $75,000 the other. The needs and habits we form are best fulfilled when we have steady, predictable resources to fund them.

Banks help us manage risk by letting us safely save when we have more than we need so we can spend later. Insurance companies allow us to pay a little over time to protect us from having to pay a lot in the event of a disaster.

In turn, they earn a profit by providing us greater income certainty than we would otherwise have.

The increased volatility of stock markets has a similar but, perhaps, more subtle effect. When we invest in a stock, we realize we are taking risk. To compensate us, we expect a greater return.

The greater the risk, the greater the return we expect. Alternately, the greater the risk, the less we are willing to pay to purchase the stock.

Financial markets have been volatile for a few years now. Because of this increased uncertainty, stock prices are also depressed. Even though many large companies have returned to profitability, we are unwilling to pay as much because the market appears so precarious.

This uncertainty is because of our concerns over domestic political dysfunction and the European financial crisis. The mere uncertainty has a depressing effect on market prices.

Until uncertainty and risk is reduced, the stock market will not want to rally to a more reasonable valuation proportional to the profits its underlying companies are earning.

The market today has factored into account political dysfunction and a European double-dip recession. More important, though, is that the market is now becoming a bit less volatile.

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