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Stochastic Risk

Jun 18, 2021

By: Dylan Ratigan

Dylan’s Weekly Note:

There is nothing more seductive to a risk seeker than a stochastic environment. A stochastic environment uniquely offers a data set that by definition cannot be predicted. While we know there will be an outcome, there is no way of knowing that outcome in advance. You might think of it as the difference between life and death. Financial ruin or unbelievable wealth. There is no middle ground. There is no in-between. There will be resolution, but there is no way of predicting what form that resolution will take. 

While the concept of stochastic risk is nothing new, its prevalence in our lives has arguably never been as profound, at least not in such a finite period of time, as we’ve recently experienced. Between the beginning of 2020 and the middle of 2021, we’ve seen this type of risk up close. It has been both unpredictable and unquantifiable. 

First we had Covid. There were those who contracted the virus but remained symptomless. At the other end of the spectrum were those who sadly lost their lives. That 600,000+ have been lost to Covid in the U.S. alone is still incomprehensible to me. I’m not sure I’ll ever come to terms with it. It was the first example of mortal stochastic risk in real time I can recall.

At nearly the same time we finally turned the corner with the pandemic, we witnessed financial stochastic risk in the form of meme stocks, crypto assets and NFTs. $1000 invested in Gamestop when it was trading for $10 turned into $500,000 virtually overnight. Investments in crypto assets and NFTs offered similar stratospheric returns. Millionaires were created in just a few days. At the other end, some of those who were short experienced financial disasters. It was stochastic risk in financial markets. 

The question becomes, what to make of this? Is this simply a unique period in time and something we’re unlikely to see again? Or, is stochastic risk part of the evolutionary process? 

Perhaps we’ve gotten too good at quantifying risk. Liquid markets and advancing technology allow us to assess risk better than at any point in history. If you believe, like I do, that markets are essentially living organisms, then it makes sense the risk found within them would evolve. If we figure out and master the rules of the game, then what’s the point in playing? 

I want to be careful and make clear I’m not equating the horrors of Covid with a game. I’m not. What I am suggesting; however, is the models by which health insurers, actuaries and markets use to assess risk are freakishly accurate in more normalized environments. However, when stochastic risk becomes the prevalent risk, those models fall short. When we know something will resolve itself at some point, but lack any reliable predictability on how it will end, models become useless and risk takers are seduced by the stochastic nature of the risk. Whether that’s good or bad remains to be seen. 

Be sure to catch Dylan Ratigan & Tom Sosnoff every Wednesday at 1pm CT for a new episode of Truth or Skepticism live on tastytrade.com.

Listen to previous episodes on Spotify, Apple Podcasts or on tastytrade.com.


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