“We must become more comfortable with risk and uncertainty."
Nate Silver’s judgment is no doubt true for everyone, but especially investors. The problem is that too many don’t know the difference, despite its now being a century since the University of Chicago’s Frank Knight (1885-1972) wrote his seminal (but unfortunately too often forgotten) paper “Risk, Uncertainty, and Profit” in 1921.
Imagine I give you a fair die and we play the following game: you pay $3.50 each time you roll the die and I pay you the outcome ($1.00 to $6.00). This game is risky. You can determine the probability of being up or down any given amount after a certain number of rolls. You can calculate what portfolio managers call “Value-at-Risk” (aka VaR); a threshold of loss you are likely to exceed with probability 1% or less after a certain number of rolls. VaR calculations were legally enshrined as a core requirement of the risk practices at investment banks by the Basel II accords in the 1990s and are now used by almost all professional money managers. In a risky game or enterprise, we know the probability distribution of expected outcomes and can determine how much risk we are willing or able to bear.
Now imagine I hand you a die that is not fair and, worse yet, changes with each roll. We play the same game as above. This game is uncertain. You cannot determine the likelihood of being up or down any given amount after a certain number of rolls. You can’t calculate your VaR since we do not know the probability distribution of expected outcomes. It can (and usually is) a major oversight to presume these games are the same!
Beginning with Harry Markowitz’ paper “Portfolio Selection” (in the Journal of Finance in 1952), Modern Portfolio Theory has generated a litany of treatises about investment risk and created an infrastructure of tools and techniques (such as VaR) to measure and control it. This has been a great benefit to investors of all kinds and sizes. However, it has often led to a dangerous complacency when investors and others (regulators, for example) have accepted these metrics and assumed they encompassed all the “bad stuff” that could happen.
There are events which are just too infrequent for us to know their likelihood of occurrence in any reasonable time frame. We discussed some of these in the summer of 2019 (when we unfortunately, but presciently, cited a pandemic as a risk we thought the world was unprepared for) and again last March (2020). Severe earthquakes, volcanic eruptions, and pandemics are just a few of the things for which we just don’t have enough data points to make actuarially reasonable risk models. Modern life has brought new potential disasters that we simply don’t have any history to rely on: a major and/or long-term interruption of power and a severe internet crash are events that could be brought about by an electro-magnetic pulse (EMP), either natural or man-made. The recent mania in a group of stocks that had been shorted heavily by hedge funds was a function of new trading platforms and social-media driven behavior; the result was losses in the billions for some funds and reflects events that were “uncertainties” outside their risk models.
What is one to do about such “uncertainties”? They are, by definition, unpredictable, so the best one can do is follow the age-old advice to stay broadly diversified (both across and within asset classes) and avoid concentrated positions in ANYTHING (what the Swiss elegantly call “klumpenrisiko”) because no matter how safe an asset seems, there is always uncertainty lurking!
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