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Risk versus Uncertainty

Investing would be a whole lot easier if we could easily characterize how the return-generating process worked. We could invest knowing the possible range, however poor, of outcomes. However, the world doesn't work that way. Investing is not like a board game with all the pieces laid out and a set of rules to follow. It is more like playing a board game where occasionally, and seemingly out of the blue, a basketball lands on the board, distributing the pieces randomly and generally making a big mess.

During any period of time, you may be able to play the game undisturbed by some random event, but you never really can say.

This is the essence of the difference between uncertainty and risk. Risk is a characterization of all the known possible outcomes. Uncertainty represents “unknown unknowns,” things we have not even thought could occur — maybe more accurately described as events with probabilities so small, but not zero, that we don't even consider them in the normal course of events.

In the non-board-game real world, these surprise events are almost always negative in nature. A little bit of imagination could conjure up some really positive events that could affect the world for the better. However, from an investor's standpoint, these positive shocks to the system should really just be thought of as found money; it's great if it happens, but not something you can really ever count on.

What investors need to do in the meantime is think about risk in two very distinct ways. The first way is trying to get a better handle on the risks in front of us. The second way is trying to determine the ways in which the world could surprise us.

Frank Knight was one of the first to make the distinction between uncertainty and risk, drawing the distinction in part because our means of forecasting the future are limited at best. We humans have a tendency to take history as it happens and extrapolate into the future. About Frank Knight, Peter Bernstein wrote, “In the end, he considered reliance on the frequency of past occurrences extremely hazardous.”

This tendency to view the future as being much like the past gets us humans into trouble in many ways, not just financially. As Howard Marks writes, “Projections tend to cluster around historic norms and call for only small changes … The point is, people usually expect the future to be like the past and underestimate the potential for change.”

 A couple of things are at play here.

The first is that we humans are an overconfident lot. Study after study shows that we humans have a tendency to overestimate our abilities. This includes our ability to forecast the future. This overconfidence leads us to take on risks that we do not even know we are taking on.

 In future chapters we will see that the stock (and bond) markets can generate negative returns lower and for longer than most people think.

A related issue is hindsight bias, or our tendency to see past events as being inevitable — we knew that would happen all along. If we

 view the past as something that had to happen in a certain way, it will make it difficult for us to peer into the future looking for disruptive changes. It may be hard to believe, but Argentina at the beginning of the twentieth century was counted among the world's developed markets.

 The intervening century was not kind to the Argentinean economy as it badly lagged its wealthy and not-so-wealthy competitors. In hindsight Argentina looks like an awful bet, but a hundred years earlier the case for Argentina as an investment was much more compelling.

Financial markets don't go much for this type of alternative reality. The best that finance does is to use historical returns to estimate future risks. This itself has its own problems because it is culling data from a very specific history. Much of the modern financial risk management infrastructure is built on top of these data. If the data are in some way biased, they will not provide the right answers to their users.

One could argue that the financial crisis occurred in part by Wall Street's reliance on a particular model that was used to price and manage the risk of mortgage securities. Everyone was pricing securities based on recent data that showed a very low likelihood of a generalized decline in national home prices. We all know what happened next. As Felix Salmon writes: “In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years' worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.”

For whatever reason, we live in a world where 10,000-year events seem to happen on a regular basis. Traditional risk modeling can capture some of the risks involved in investing but, by definition, miss the most important risks. This gets to the difference between risk and uncertainty. Risk, while not modeled all that well, is generally captured by the markets. That is why most earnings or economic releases come along with a collective shrug of the shoulder from the markets. The news was already well anticipated.

A healthy respect for uncertainty changes your fundamental outlook for investing. It makes you think about building redundancies

 into your portfolio. While it is unpleasant to think about worst-case scenarios, it does help clarify your thinking. Thinking about how to construct an “all-weather portfolio” that you can live with through good times and bad is a useful exercise. The worst investment strategy is one that cannot be followed because we feel compelled to jump ship at the most inopportune times.

Any investor interested in having a long-lasting and fulfilling investing career needs to avoid too many losses of too large a magnitude. This is why we started our discussion of investing with risk and not returns. As Benjamin Graham wrote, “The essence of investment management is the management of risks, not the management of returns.”

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