Ivan Shaliastovich, an associate professor of finance at the Wisconsin School of Business, researches uncertainty, an area of interest since his days as a doctoral student at Duke University. It’s the subject of his recent conversation with WSB, and the focus of two of his papers: “Good and Bad Uncertainty: Macroeconomic and Financial Market Implications,” which looks at macroeconomic uncertainty and aggregate growth, and “Good and Bad Variance Premia and Expected Returns,” which focuses on the options market and the risk associated with good and bad uncertainty.
WSB: Tell us about your research. How you did you get started in this line of study?
Shaliastovich: I’ve been working on this idea of how we think about uncertainty since my Ph.D. years. We’re not sure what’s going to happen in the future. As humans, we’re adverse to this—psychologically, we don’t like it. In daily life alone, we’re faced with a lot of uncertainty that affects our decision-making about things like our finances, jobs, and families. For example, you might wonder if your daughter will go to college, and if so, which school she might choose. Or perhaps she has already applied to Harvard, MIT, and Stanford; it seems like things are going well, you’re just uncertain about which of the three she will attend. Conversely, maybe she is struggling and it’s unclear if she will graduate high school at all. All three of these examples are uncertainty, but each is markedly different in terms of our behavior and whether we think about or experience this uncertainty as “good” or “bad.”
Putting the discussion back into a financial context, how can we then think about anxiety and uncertainty more broadly from an economic perspective in terms of workable models? What are the quantitative and qualitative effects of uncertainty, and to what degree is their impact? These are the kinds of questions I’ve been examining throughout my career, playing with these different aspects of uncertainty.
WSB: Can you elaborate on this idea of good and bad uncertainty in relation to economic markets?
Shaliastovich: This is a “big picture” answer that doesn’t delve into all of the technical details of our study, but ultimately we’re getting away from uncertainty being conceptualized as a single entity. For example, I’m uncertain about the future—that makes sense—but that’s not the complete picture because within that uncertainty we can think about an upside and a downside.
In our research, we’re trying to show that it’s important to separate these two—good and bad—aspects of uncertainty. They have very different impacts on the economic markets. Investors also view these types of uncertainty differently, not just quantitatively but qualitatively. If we put both good and bad uncertainty into the same bundle of variance, you’re going to miss these effects.
At the firm level, dealing with uncertainty is a big part of their work. If there is uncertainty about a product and whether there is enough demand for that product, firms might invest less—that’s bad uncertainty. If bad uncertainty goes up and investment goes down, we see a decline in future growth rates in the economy and the equity prices are going to fall at the same time. A rise in bad uncertainty is just as you would expect: bad news.
With good uncertainty, we see the opposite effects. Let’s say there is an expansion in the economy. There might be some new ideas coming in, some new opportunities to invest, but we’re just not yet sure how good they are going to be. Or for example, the introduction of the web gave us growth opportunities. We may sense that this might be a positive venture for us but we’re not sure how positive. That’s good uncertainty. Unlike bad uncertainty, it actually boosts investment, economic growth, and the stock market.
WSB: Where do you see your research going in the future?
Shaliastovich: One thing we are looking at now is whether there’s a structure of the economy that could create or lead to this good versus bad volatility. What are the underlying economic mechanisms for generating uncertainty about innovation and growth versus recession and downturn? How should firms behave and what kind of economic shocks are they exposed to? Also, exploring this idea of networks across firms: it’s possible that firms can connect through a network and create a cascade of new ideas. There’s room to grow with this idea.
Today, we’re seeing more and more in research this notion of uncertainty as being important. In the 20th century, there was a lot of work done in finance and the stock market. Of course, uncertainty is not a new concept, but in the 21st century, we started hearing about it from an economic point of view. There also appears to be a greater appreciation of the subject not just from a statistical or a finance point of view, but even from a broader academic and social standpoint. Uncertainty is not just a sideshow. It can have a first-order impact on human behavior.
Read the papers “Good and Bad Uncertainty: Macroeconomic and Financial Market Implications” published by the Journal of Financial Economics and “Good and Bad Variance Premia and Expected Returns” published by Management Science.
Ivan Shaliastovich is the Thomas D. and Barbara C. Stevens Distinguished Chair in Finance and an associate professor in the Department of Finance, Investment, and Banking at the Wisconsin School of Business.