Humor: Island Stocks

Original Source

Inflation or Deflation?

One of the most tricky financial phenomena is INFLATION....

A continuing inflation of an average 2% or 3% devalues pensions and erodes saving accounts on the long run.

A sudden shock of inflation, hyperinflation, vaporizes the assets as well as the debts.

It could be (the only) way out of this sustainable crisis we seem to be dealing with. The other side, credit deflation, is also a potential 'Crisis Solver Candidate' for restructuring the enormous debt in our economy.

Which one will win?  Price (hyper)inflation or credit deflation? That's the key question....

Artificial

Just like the complete arsenal of asset classes in our financial 2012 society, price inflation is not (longer) a result of natural price mechanisms directly or indirectly based on supply and demand.

Worldwide, governments and central banks (FED, ECB, etc) are trying to control inflation  to keep economies as stable as possible and to create an economic environment with growth potential, while restructuring debt step-wise on the long run to 'acceptable' levels....

Historic Price Inflation

With the above formulated insights, let's take a look at how U.S. price inflation and deflation have historically developed on the long run:

A visual analysis of this inflation graph clearly shows the hyperinflation waves (most often) are followed by a hyperdeflation avalanche. However for more than 56 years on a row now, inflation has been only positive. So the key question stays: Are we heading for a major devaluation crash or a final hyperinflation scenario after which what (?) happens????

To get (visual) sight on this question, let's take a look at the 10Y and 50Y moving averages::

At first sight, one could visually conclude that it's most likely that inflation will rise again..... On the other hand, looking 'long term' deflation seems inevitable......   But who really knows?

Detail Figures

Maybe some quantitative information gives more insight:

From this we can conclude that the average arithmetic inflation (1.38%) as well as the compound (geometric) inflation (1.13%) is modest and the standard deviation (considering the low averages) is relatively high.

This calls for a period inspection:

Or in plain numbers:

Now we have a clear view! Until 1900 the average yearly inflation was around 0%. From 1900 to 2000 we suffered from an increasing inflation, mainly due to a number of crises. As from 2000 of, we try to push inflation down, with limited success.

Hyper Risk

All these charts lead to a better view on inflation, but what about the risk of 'hyper' inflation- or deflation.

A short look at the frequency table helps us to get a picture of the inflation risk distribution:

I'll leave it up to you, to draw your conclusions from this last chart.

Mathematica

More insight and feeling about how inflation correlates with some important economic variables can be developed by playing around with the next Mathematica Applet.

To work with the applet, allow the Mathematica plugin to download (it's safe).

This year (2012) inflation come out will be somewhere around 2.1%.

One of my next blogs will allow you to Mathemetica(lly)  'play' with inflation (including the 2012 inflation outcome), so you'll be able to grasp inflation finally.

Finally: Keep Cool!
Until then....., keep cool while watching the inflation balloon rise until it will (not) burst !!! , as researchers in a "Bursting balloons and anxious faces study"  concluded that a person is willingly to take more risk when a watching friend suppresses facial expressions of anxiety. "Such a finding has obvious implications for the interpersonal emotion regulation of advisors or counselors intervening in real world decision making situations". 

Links

- Excel Spreadsheet with inflation data and charts

- Inflation Wikipedia

- Study Bursting balloons and anxious faces

What's your Risk Intelligence Quotient?

One of the main problems in risk management is that we (oblivious) overestimate our risk knowledge.

Example
If for example financial institutional boards have to define a risk-return strategy, they may overestimate the probability that the historic return level of a certain asset class will also be the expected future return level.
Or they might simply overestimate the quality of their investment advisor.... ;-)

To define an optimal asset mix on basis of a risk-return strategy, it takes more than just estimating future returns and/or risks of certain asset classes.

To make these kind of high-impact decisions it's important to train board members on knowledge of economic schools and theories and also on the relationship between economic developments and financial parameters like unemployment, inflation, GDP-growth, specific asset class return and risk parameters, linear and non-linear effects, and so on......

But more than that, it's important that board members - as they have learned all this - become aware of the fact that the more they know about risk and uncertainty, the more they'll realize that the outcome or certainty of a future development is intrinsically highly unsure. This last recognition will have significant consequences for the final choice with regard to the optimal asset mix given the risk appetite.

Risk Intelligence Test 
Eventually it all comes down to

Kowing how much you know

as Dylan Evans, author of the book "Risk Intelligence"states in the Dylan Ratigan Show

According to Dylan : 'Risk intelligence is not about solving probability puzzles; it is about how to make decisions when your knowledge is uncertain.'

Dylan Evans developed a short (5 min) Risk Intelligence Test.
See, if you can pas the test as an actuary or risk manager...
You can take the test here.
The test is also available in Dutch.



Links:
- Homepage Dylan Evans
- Dylan Evans on Twitter
- Dutch Risk Intelligence Test
- Dylan Evans: Emotional Equations (Pdf)