Risk and Uncertainty

Risk and Uncertainty

In our day to day lives, the terms risk and uncertainty are often used in the same breath.  There is a difference, though.  Risk and uncertainty are not one and the same.  In More Than You Know, Michael Mauboussin had the following to say about risk and uncertainty:

“To see another distinction between risk and uncertainty, we consult the dictionary: Risk is “the possibility of suffering harm or loss.”  Uncertainty is “the condition of being uncertain,” and uncertain is “not known or established.”  So risk always includes the notion of loss, while something can be uncertain but might not include the chance of loss. 

Why should investors care about the distinctions between risk and uncertainty?  The main reason is that investing is fundamentally an exercise in probability.  Every day investors must translate investment opportunities into probabilities-indeed, this is an essential skill.  So we need to think carefully about how we come up with probabilities for various situations and where the potential pitfalls lie.”

Mauboussin points out that objective probability is the basis for risk, but subjective probability underlies uncertainty.  If you roll two dice, you can’t be sure how they will land but the possibilities are limited.  The number you roll will be between 2 and 12.  With casino games like roulette, there’s risk, but not uncertainty.  The outcome of a war, on the other hand, is quite uncertain.  We can make educated guesses, but anything could happen.

In a 1999 commencement speech at the University of Pennsylvania, then Secretary of Treasury Robert Rubin discussed uncertainty and how we should approach it in terms of our decision making.  He said we have to acknowledge that the vast majority of our decisions will be made based on imperfect or incomplete information.  All we can do is intelligently appraise the information available and come to a reasonable conclusion.

Whether we like it or not, financial markets play a big role in all of our lives.  For investors, finding a good way to handle the known uncertainty is incredibly important.

In his new book, Organizational Alpha, Ben Carlson spends time discussing the importance of the decision-making process.  He draws on Charley Ellis’s description of three options investors have for succeeding in the markets:

  1. You can work harder than your competition in hopes of gaining an informational edge.
  2. You are simply smarter than your competition.
  3. You are more rational than your competition and utilize a long-term process.

Carlson says that many investors believe Option 2 is an appropriate fit for them.  This belief holds even though success by way of intelligence alone is achieved by only an extremely small percentage of the most talented investors.  The majority of investors are even further mistaken.  Believing that Option 1 is the righteous path to success.  Hard work pays off, right?  Unfortunately, while tenacity and brains lead to better results in many ventures of life, such is not always the case when it comes to investing in uncertain financial markets.

Rather than trying to outsmart a complex system, Carlson suggests that Option 3 offers the best chance for most investors to succeed.  By acknowledging the complexity of the system and the limitations of their own abilities, investors can focus efforts on developing a process to embrace uncertainty, rather than trying to explain it.

As humans, we like to identify a cause for every effect, so the concept of literal uncertainty is very difficult to internalize.  It requires humility.  We have to know what we don’t know.  To be successful, we must spend time developing a structure that operates within those constraints.  Risk can be managed with math and science but uncertainty requires a more nuanced approach.

Financial planning and investing are ongoing processes.  What is right today, might not be right tomorrow.  Don’t waste time trying to attach a cause to every effect.  Make sure you see the forest for the trees and when something within the system changes, have your plan ready.  Accept the change, adapt and move forward.

Further Reading…

The Invisible Alpha

Real Financial Planning

At Ariadne, I work closely with families and individuals to organize their finances and utilize their resources to design a life they love.  If you are interested in a straightforward, no-gimmick approach to financial planning that focuses on you and your needs, don’t hesitate to get in touch.  I’d be happy to have a conversation.

Tim Brennan


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