Risk Management: the Search for Villains

One of the basic principles of Sun Tzu's strategy is that the future is not predictable and that things can change, sometimes dramatically over time. However, another principle is that change tends to balance itself out over time. In finance, the recognition of these principles takes the form of future trading, where a group of "speculators" assumes the risks of unpredictability in hopes of leveraging the principle of balance. This works pretty well because, while each of us is almost always wrong in our predictions, the wisdom of crowds does pretty well over time. Politicians often portray future traders as "villains" because a large part of their "elect me" narrative revolves around the misconception that the future can be predicted, planned, and controlled by small groups of individuals if only we had "good government." Yet, in practice, government prohibition of future trading makes markets many times more volatile and chaotic. Here is a great example from the 1950s when the US government saved us all from the evil onion traders (via InstaPundit). Does anyone want to see similar volatility in gas prices? As I mentioned in this earlier post, instead of branding those who do us the favor of assuming short-term risk as "evil," politicians should leverage the existence of speculation by passing legislations that makes future traders think that near-term fuel prices will fall instead of continue to rise.