Political scientist Ted Lowi once said, “Where there’s debt, there’s hope.” And certainly that’s been the optimistic philosophy with which the financial powers-that-be operate. But fundamentally I think Lowi was trying to get at the way we think about money and the future: we have always understood it is a trade-off between risk and reward. Without debt–or risk–there is no opportunity of reward. Since the seventeenth century, mathematicians–with economists, financiers, and gamblers close on their heels–have been working to express the perfect balance point in between.
Which brings me to the stock indexes we are watching with such fascination today. After the stock market crash of 1929, economists began to focus heavily on risk assessment in investment, and the result was the first modern method for valuation of stocks: discounted cash flow analysis. This was based on notions about the time value of money, and it gave investors a great tool for quantifying uncertainty.
Over the past 80 years, a number of specialized versions of this kind of risk analysis have been introduced into standard accounting practice, and now you can even go online to test some of these methods.
But, as the wild ride of the global markets in past weeks has demonstrated, we still need to improve our forecasting methods. But never fear, necessity is the mother of invention. If the crash of 1929 brought us discounted cash flow analysis, what kind of quantitative forecasting will the current upheaval of the markets bring us?
