Process, Outcome And The Complexity Of It All

I very much appreciated this perspecitve offered by Dylan Grice of Société Générale:

“All outcomes are caused by an underlying process. In very general terms, all we did by constraining the QI to have a 2% tracking error was impose an outcome on a process. But as soon as we did that we also changed the process. Instead of including stocks that matched the criteria we were looking for, we included stocks that didn’t because doing so helped us hit our tracking error target. But once we change the process we necessarily change other outcomes. Thus, while we achieved the outcome we were targeting, we negatively affected the outcomes we weren’t targeting (returns, volatility and drawdown). The overall effect of targeting one outcome was then detrimental.

It might be tempting to think that tracking error is just the wrong thing to target. But I’d argue that for even mildly complex systems, any outcome is the wrong thing to target. As we just saw, targeting one outcome of such a process changes that process, and changing the process subsequently changes all the other outcomes. In any kind of complex system where the underlying outcome generating processes aren’t well understood – whether a company, or a society – the effects of changing the process won’t be well understood either. Unintended consequences must ensue.

Yet even a cursory glance at the news shows ‘outcome targeting’ to be endemic: in response to the damage caused by Basle II, we’re given the ‘new and improved’ targets of Basle III (now already being traduced); the insurance industry now faces Solvency II targets; investors fret that banks won’t be able to hit their RoE targets; investors wonder if China will be able to hit its 8% GDP growth target; most major central banks target some sort of CPI inflation rate.

This is lunacy. How much damage has already been caused by banks that overreached themselves in trying to meet their RoE targets? How lopsided and capital destructive has China’s insistence on hitting its breakneck GDP growth targets at all costs been? How much of today’s painful credit deflation was caused by the credit inflation central banks pumped up while aiming for their CPI inflation target? In targeting these outcomes, underlying processes were distorted. Unforeseen outcomes resulted. But regulators continue to prescribe capital targets, banks continue to target RoE, China continues to target a growth rate, and central banks continue with ever more experimental methods in defence of their inflation targets. Indeed, today in Europe we’re seeing the unintended consequences of imposing outcomes (i.e. an exchange rate) on the eurozone economies.”

Good stuff . . .

Popular Delusions The tyranny of targets: process, outcome and the complexity of it all
Dylan Grice
Société Générale, GLOBAL STRATEGY 15 June 2012

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