For a long time, I’ve been thinking of getting a new patio. And yet the job remains undone. This isn’t simply because I’m lazy. It’s because of an economic idea that should influence our thinking not just about our investments but also life generally – the notion of optionality.
I don’t know what type of paving I want or how far to extend the patio. Because of this, I’ve delayed the project. Right now, I have an option on a new patio, which I would lose if I were to actually get the patio. Uncertainty makes it more valuable to hold on to this option rather than exercise it now. Just as price volatility raises the value of a financial option, so uncertainty about my tastes raises the value of my option on that new patio.
This thinking applies to investments generally if they are irreversible – that is, if we cannot easily recoup our money: if I decide that I don’t like the new patio, it would cost me a lot to replace it. Back in 1986 Robert Pindyck of Massachusetts Institute of Technology showed that companies thinking about new investments had call options on those projects and that uncertainty caused them to hold on to to those options rather than exercise them – in other words, to delay investing. Even if a project seems profitable today, you might delay it if you expect lower interest rates, better technology or stronger demand to make the project even more profitable in a few months’ time.
It was for precisely this reason that Gordon Brown spoke endlessly of “no return to boom and bust” while he was chancellor from 1997 to 2007; he wanted to reassure businesses that policy uncertainty was low and thus encourage them to invest. And it’s this mechanism that has led Stanford University’s Nick Bloom and colleagues to estimate that uncertainty about Brexit has depressed capital spending.
It’s not just companies that have real options. So do many of us. If you’re thinking of buying a new house or car or some home improvements, you too have them.
In fact, many of us have a more significant option – on retiring. For many of us such a decision would be difficult to reverse: it’s usually far easier to hold on to a good job than it is to find one if you are out of work. This means that those of us considering retirement have, in effect, a call option on retiring. And uncertainty gives us an incentive to hold on to this option – to continue working.
The uncertainty here is not just about future returns, important though this is. It’s also about our future outgoings. For me, one source of uncertainty (which I hope is not purely hypothetical) is whether I might meet somebody with expensive tastes, or whether my spending might increase when I become a flaneur. We all have different uncertainties, not least of which is whether we’ll need expensive social care when we are older.
It’s not just retirement that’s an irreversible investment and therefore a real option, though. So too are illiquid assets. For many of these, such as private equity, property funds or collectibles such as classic cars, the solution is simply to limit our exposure to them by having them as only a small part of our portfolio alongside a cash holding. For housing, however, it is not so easy to do this. This is one reason why house prices fall a long way and for a long time during recessions. It’s because recessions, and even the memory of them, increase uncertainty and so depress demand.
Thinking of optionality can help us in another way. We should think of everything we do and own as having a distribution of possible pay-offs. A deep out-of-the-money option is worthless if exercised now, but has the small chance of huge upside. Conversely, an in-the-money option has value today but it could become worthless.
You might think that speculative stocks are a form of out-of-the-money call option as they give us the small chance of huge returns. Not quite. On average, these tend to be overpriced: Aim stocks have underperformed mainline ones since the market began in 1995. There is therefore considerable downside risk to them. Private equity might be a better example. One or two start-ups do have huge upside potential. But you have to buy several losing companies in order to get these. There is, however, little evidence that private equity investment trusts are systematically overpriced in the way that Aim stocks are.
A better example of out-of-the-money and in-the-money options might be career choices. Acting and pop music are out-of-the-money options: most people entering them earn little, but there are huge rewards for a small minority. Many bog-standard jobs on the other hand are in-the-money. They pay tolerably well from month to month but have little upside and large downside – the risk of redundancy.
It’s not just jobs and assets that are subject to optionality, however. So too are our everyday life decisions. Getting out and meeting people are free options with massive potential upside: you might meet the one, or learn of a great job or business opportunity. One of the best bits of advice Nassim Nicholas Taleb gives us in The Black Swan is to spend less time on grunt work and more time looking for these cheap options with big potential upsides. Perhaps, therefore, there’s much to be said for becoming a flaneur.
