The phrase “butterfly effect” refers to a well-known, and often misunderstood, concept in the universe. Its roots come from meteorologist Edward Lorenz, as it describes something along the lines of a butterfly flapping its wings in Brazil potentially setting off a tornado in Texas.
As a dramatic oversimplification of his concept, Lorenz was indeed illustrating the core tenet of chaos theory: small, almost insignificant differences in initial conditions can lead to vastly different results in chaotic systems. But how does a butterfly connect with probability and, more importantly, connect to finance and risk?
Unpacking Chaos: Beyond Simple Cause and Effect
Chaos is not just ‘Am I going to flip a coin or not?’ It’s important that we understand chaos theory is not about randomness. Chaos is simply about deterministic systems that are very sensitive to their starting conditions. Due to the extreme sensitivity to conditions, even if we have all the data we could possibly need, we still could not predict the long-term behaviour of such systems.
- Nonlinearity: In a nonlinear system the outputs are not proportional to the inputs. A small push does not equal a small pushback.
- Feedback loops: The outputs can be fed back into the system, and small changes can be magnified with time.
- Unpredictability: Long-term forecasts are largely unpredictable, as in we could have rules, but we could not make claims about the long-term behaviour of systems with small, linear changes.
This inherent unpredictability is why understanding chaos is essential in advising on financial risk tools and implementing financial risk management tools.
Probabilistic Considerations: An Approach to Unforeseen Future Events
While chaos theory highlights the limits of predictability, probability theory can alleviate the situation by allowing us to estimate probabilities for one or more possible future events. We may not know what will occur, but we can assess the probability of many possible outcomes.
From Certainty to Probability.
From Certainty to Likelihood
Precision in predictions is impossible when it pertains to chaotic systems. A common approach in financial modelling is to move from precision-based certainty (e.g., “the price of the stock will be X, on that date”) to plausible probabilistic outcomes (e.g., “there is a Y% chance the price of the stock will fall between A and B”). This shift in approach is essential for organisations, institutions, etc., that have a business interest in fluctuating markets.
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Modeling Extreme Events
The “Butterfly Effect” can lead to “black swan” events, which are negligible probability and very high impact events that we cannot generally exert much influence to predict. Probability theory, particularly methods such as extreme value theory or scenario analysis, supports financial risk management and mitigates extreme outlier events by estimating probability and expected value impact, no matter when these events may occur.
Understanding outlier events is an essential skill for professionals, usually ascribed and discussed at length in the CMA US course of educational programming.
Navigating the Financial Jungle: Strategies in a Chaotic World
How do businesses and investors adapt when the financial markets are unpredictable?
- Diversification: The traditional strategy of not putting all your eggs in one basket reduces the severity of unpredictable volatility in any one asset.
- Stress Testing: Running extreme market scenarios allows organisations to endure and understand their weaknesses. This goes beyond the average case and includes preparing for the consequences of the “butterfly effect”.
- Agile Strategies: As opposed to relying entirely on a long-term plan, you can use strategies that can be easily adapted to knowledge or information that you did not have in the first instance and environmental inertia. In this case, even if you don’t have accurate predictive forecasting, your adaptive strategy would reduce the risks it aims to control.
- Scenario Planning: Wind tunnels are widely and effectively used in construction. They are built to replicate air and wind conditions in a specific region and can account for a wide variety of outcomes. To a lesser extent, scenario planning is just as important, and even necessary, in your business. It’s important to consider several possible futures, both likely and unlikely. The principles and skills needed to do this are available in the strategic planning modules that all CMA US programs now offer, e.g., versatility and preparedness instead of perfection.
Final Thoughts
For professionals participating in internal financial examination and strategic decision-making, the financial risk management credential offers the tools to work in these environments. The CMA US credential addresses how to use management accounting as a steering mechanism for organisations, allowing the organisation to react despite the confusing chaos created in the external markets.
If we take into account the limits of prediction from chaos theory and the power of likelihood from probability, we can construct improved and more resilient financial strategies, realising that even the smallest flutter may have grave consequences.
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