According to wikipedia Conflation is the merging of two or more sets of information, texts, ideas, opinions, etc., into one, often in error. This may lead to misunderstandings, as the fusion of distinct subjects might obscure analysis of relationships which are emphasized by contrasts. Why does conflation happen in the first place? There are several possible factors which in some contexts may be co-existing and overlapping:
- gratuitous (over)simplification driven by laziness or habit
- literacy gaps in either the originator or the receiver of information
- an objective to frame, mislead or otherwise be economical with the truth
In this blog post we discuss a number of interrelated financial terms whose precise meaning is frequently intentionally or unintentionally obscured. Those terms may, like a Rorschach Blot , mean different things to different people, but unlike this famous psychological test, such ambiguity in weighty financial matters can have adverse consequences.
We stick to a few important “clusters” of terms that are of global significance across most of the financial universe. One can find many more ambiguous terms when diving into specific sub-domains, but those tend to become increasingly technical, tied to jargon and conventions and thus of more specific interest.
1. Real Assets and Fake Assets
An asset is something of value (see below for challenges with the value concept) that can be owned by somebody (a person or a legal entity) and, in addition, provides some type of benefit to the owner.
The word asset has positive connotations, hence it is not surprising that it frequently gets “overloaded” and used in ways that stretch its meaning beyond recognition. Think of the following diverse dimensions that differentiate the vast universe of “assets”:
- Productive versus non-productive assets: A productive asset is an artifact that will (in most future states of the world) generate something valuable: A piece of fertile land planted with fruit trees will produce fruit, a factory together with some raw materials will produce gadgets. A productive asset is any artifact that can generate something of value, in particular when mixed with human involvement (labor).
- Real assets versus paper assets: Not everything “real” is productive. A mere plot of barren land is not a productive asset. Yet it is a real asset. Somebody may indeed derive value from it, by using it, e.g. to mothball airplanes during a pandemic, thereby preserving some other value. In contrast, financial assets are essentially contracts (heretofore written in paper, hence paper assets. They are typically specifying terms of future exchanges of money or other assets. Their value derives from the anticipated value of such future exchanges. Financial assets do not produce anything tangible but in general do produce cash flow, which is a sort of universal valuable (as we will see below on the Cash term). Because future states of the world as so essential in the structure and use of financial assets, the associated uncertainty becomes an extremely important aspect (see below on the Risk term)
- Tangible versus intangible assets. Financial assets are quite abstract but they are at least tangible in that the terms are explicitly spelled out in documents that are enforceable under applicable laws. In contrast, in the case of intangible assets the value can be fairly subjective.
Why are there so many “assets”? The proliferation of Asset Classes has as a valid starting point the complexity of modern societies. The large material footprint of modern economies already offers ample opportunity to define real assets. There are, e.g., uncountable many physical artifacts being manufactured for consumption, either by end-users or intermediaries. Every pool of such artifacts is an asset. Any facility able to produce such assets is an asset in itself. Etc.
Next to the above real processes, though, there is a long-running trend of financialization or monetization of society which converts agreements (such as various business contracts or legal claims) into financial assets valued using a common unit of account. For example every perceived risk for which there is a willing insurance intermediary can be converted into a corresponding “insurance asset” through the origination of insurance policies. There is a cookie-cutter aspect to this process in which financial intermediaries earn a living by creating and supporting an ever expanding range of asset classes. This expansion comes complete with occasionally dubious claims of Risk Diversification based on stylized and sketchy computational work.
A most poignant such recent manifestation is the claim that a portfolio of diverse, newly minted, “digital assets” is somehow diversifying investment risk. This warning brings us naturally to the second important and frequently conflated term: investments.
2. Investing versus Gambling versus Pyramid Schemes
The concept of an investment is very frequently conflated alongside the implicated assets. This is natural, given any investment requires the exchange of something of value (e.g. cash, time, other asset) for another “something of value”, i.e., another asset. Why would one do any such asset exchange in the first place? The investor may have the expectation of accruing a positive benefit (economic, financial or otherwise) in the future. An investment is thus the act of obtaining ownership of an asset with the goal of generating an anticipated (but in general uncertain) future benefit. The nuance around the term investment is always associated with the nature of the underlying asset, but is linked also heavily to the objectives of the investor.
A relevant dimension here are investor preferences towards the range of possible “benefits” from a given asset, their likelihood and magnitude and, importantly the mechanism by which they might be generated. The risk/return profile is the formal name for the first group of considerations (likelihood and magnitude of benefit). We thus talk about speculative investments, lotteries etc., in circumstances where the “investment” has an extremely risky profile where a very high return is coupled to a very low likelihood. It is well known that the line separating compulsive gambling from “utilitarian” investment is not black-and-white.
The mechanism of value creation is another critical aspect of investments that is sometimes conflated. This is not related to the risk/return profile per-se. Rather, the fundamental question here is: Will the investment confer any value in the absence of another future “investor”? In other words, is the value derived solely from the expectation that there is a “greater fool” to offload the asset at some point in the future? While the answer would seem to be always easily available, in modern markets (see below) with a vast machinery of generating and trading assets it may not always be obvious if an investment would exist without a pool of “idiots born every minute”.
3. Cash versus “Cash Equivalents”
Everybody thinks they know what cash means. In the universe of assets it would be considered the ultimate safe asset or a strategy of abstaining from investment. Cash is defined as anything that is widely accepted in payment for goods and services and in settling of debts. It is thus serving one of the core functions of Money (medium of exchange). Yet there are significant differences in the various manifestations of “cash” which under specific circumstances can show dramatically different behavior (risk).
Cash in hand versus cash in (central) bank
Physical versus Electronic Cash: The most obvious form of cash is paper money and/or metal money (coins, also called “specie”). This form has tangible physical manifestation (one can hold this type of cash in their hands or imagine stacking it up all the way to the moon). As everybody learns from an early age, physical cash might get destroyed (get lost, stolen, damaged, etc) but it never becomes anything more than is stated on its face (which is its face value). This type of cash has thus no immediate price risk and also no upside potential as an investment. While it is the ultimate “safe asset”, safety is a relative concept. Longer term risks that affect cash are inflation (loss of purchasing power) and in extreme cases the risk that it will cease being legal tender (accepted by society for exchanges).
Electronic “cash” is an account implemented in a private bank arrangement. This type of cash is less subject to damage and loss, while still subject to inflation and legal tender risk. It carries in addition the Credit Risk of the issuing bank (it is a claim on that bank). As illustrated by historical bank runs, this can be occasionally a very material risk.
A variation of this type of cash that is currently being discussed is an account with a central bank (a facility heretofore available only to financial institutions) which could dramatically reduce the credit risk of cash account holders. This type of cash is still theoretical but the ongoing large scale digitization of economies and financial systems suggests that some form of CBDC will, more likely than not, be added to the spectrum of different types of “cash”.
Conflating different forms of cash and their risk profile is not just for the regular person. This faux-pas has been a common occurrence in technical financial literature and practice. In the stylized financial models and systems used widely in analysing investments one frequently encountered the notion of a risk-free cash account. This was supposed to be an account with some imaginary entity that returns (produces interest) equal to the prevailing interest rate set by the central bank. It has been assumed (backed up by an arbitrage argument) that this rate is always positive. Otherwise, in case the rate is negative, one can always move their funds into physical cash, or so the argument went. In practise, we learned in recent times that this arbitrage may persist due to the various costs, risks and inconveniences of physical cash.
The puzzle of money
The above discussion just scratches the surface of all the issues emerging from the imminent possibility of digital money. Do you feel confident about all the different notions of cash and money? Why not try out the Puzzle of Money at the Open Risk Academy!
4. Value and Values and Greenwashing
We saw already that deriving Value is the deeper motivation and justification for creating the concept of investable assets. Given the prior discussion it would not be surprising if it transpired that value was not a crystal clear term. Which value (or values) and benefits are being implied? This is a cultural choice with profound implications. Most commonly value means monetary value, measured in some units of account, which in turn confers the benefits that money can buy.
Let us start with Value Investing, an old investment paradigm that involves buying securities that appear underpriced (undervalued by the market - see below for that term) by some form of more fundamental or insightful analysis. The implication here is that there is “hidden monetary value”, a “secret” treasure trove that is not currently captured in the market price (but is likely to do so in the future). This notion of “value” is still deeply coupled to monetary value.
Contrast the above use of the term value with Values Based Investing. This investment paradigm posits that investments should be made not with sole reference to the expectation of monetary value but in accordance to the investor’s broader societal values and moral disposition. The modern incarnation of this philosophy finds expression in major trends such as ESG Risk Management which aim to incorporate a range of environmental, social and governance criteria and factors into the investment process.
The process of aligning finance with broader sustainability goals and values is termed Sustainable Finance . The potential for conflation in this loose and rather incoherent collection of objectives and potentially conflicting values is enormous and there is already a term for this: Greenwashing
5. Markets and Corporate Structures
The term market (and the plural forms markets) is frequently used to denote the particular economic and financial organization of large parts of the modern world. Yet that umbrella term can hide drastically different arrangements. Markets come in vastly different shapes and forms. As collective behaviors that aim to facilitate exchange between private interests they probably exist since time immemorial. Yet elements such as: who are the natural buyers and sellers of assets, “who knows what” about market transaction activity, what are the auction mechanisms etc., are all important defining attributes of any concrete market. All markets are not the same. These and other attributes can make a dramatic difference in the functioning, fairness and overall health of markets. For better or worse, in modern, digitally intermediated, exchanges there is considerable further scope for Market Pathologies .
Another common conflation of the term “Markets” is its use to imply the important - but totally distinct - concept of (private) corporate enterprise. Corporations are virtual (legal) entities that may both
- trade assets such as the inputs and outputs of production and
- whose various claims (equity ownership, debt) can be traded in various markets.
Corporations are not intimately related to markets (the organized exchange of assets). One can imagine a market economy without corporate entities. E.g. trade happens only between individuals (and possibly state entities). Vice-versa, one can imagine economies with corporate entities but without organized market exchanges. In fact not even a monetary system is strictly necessary for functional corporate structures: One could imagine corporations engaging in barter trade of all required assets and the specification of their liabilities “in kind”.
6. Volatility, Risk and Uncertainty
Risk is a massively misused term and for good reasons:
- In contrast to Assets and Investments that point to a positive, energetic and hopeful attitude, Risk has obvious negative connotations and conjures up disaster and loss.
- Risk highlights the inherent uncertainty embedded in any asset and/or investment, a concept that is profoundly difficult to pin down. This has given rise to a range of methodologies that aim to frame and contain that complexity. While in a conflated use assets and values have an exaggeration bias, risks will instead an underestimation bias.
But what is Risk? We mentioned risk already several times. It should come as no surprise that risk, too, is a term is frequently conflated and misused. The very definition of Risk is subject to much ambiguity and the implications for the quality of risk management are quite profound
In fact risk is such a bother, it is frequently being completely exorcised away, as in: “We do not take any risk”. This statement more frequently than not actually means “We do not take any undue risk”, or even, “We do not pursue anything illegal”. But more frequently than note, there is an elaborate framework for Risk Management that recognizes at least some risk and aims to provide assurances that things are under control. The tools used in such frameworks depend on the Risk Type . There are so many of those, one must resort to an elaborate Risk Taxonomy simply to ensure everything is accounted for.
Volatility is commonly associated with markets and market risk. One of its popular but wrong associations is with downside risk (the risk of significant loss). In more technical context it has actually a fairly different (actually two different) meanings. It is a symmetric measure of uncertainty (captures both downside and upside risk):
- The first such alternative meaning of volatility is as the historical volatility of market data. This is the degree of variation (in statistics known as standard deviation) of a trading price of an asset over time. Within this statistical exercise there is still room for many alternative definitions. For example on the basis of different length of timeseries, the handling of values (e.g. logarithmic returns), the observation frequency, the treatment of any missing data etc. etc.
- Another concrete and (in principle) well-defined volatility concept is so-called implied volatility. This notion of volatility has less to do with historical volatility and is instead a measure of forward-looking market expectations about the future price volatility.
Is it Risk, is it Uncertainty or maybe a Black Swan?
Uncertainty versus Risk* is a popular discussion topic among risk managers, especially after major risk management disasters. The debate can get really hairy and drift into deep philosophical areas about the nature of knowledge etc. Yet the significance of having an unambiguous language toolkit around these terms should not be underestimated. The Taxonomy of Uncertainty post explores the very many nuances shared by these two concepts.
The epitome of conflating the risks inherent in any situation is so-called black swan theory. A Black Swan, according to wikipedia , is an event with the following three attributes:
- it is an outlier, it lies outside the realm of regular expectations. Nothing in the past can convincingly point to its possibility (thus not even with a low probability)
- it carries an extreme impact
- in spite of its outlier status, explanations for its occurrence are produced after the fact, making it explainable and predictable
It is not clear if any risk event can rigorously be defined as a Black Swan. Financial crises and pandemics certainly do not need apply. They are recurrent phenomena. A cynical (re)definition of “Black Swan” might be any and all significant risk events that are intentionally or negligently mismanaged…