Risk is the direct result of a random event which has a well-defined and measurable outcome. The chance of an effect – whether it’s tomorrow’s forecast, a card game, or successfully climbing Mount Everest – can be determined by using either the practical observance of past events, or former patterns of behavior when theoretical models are not available or reliable. Uncertainty is more intricate than risk: Whereas risk can be observed and quantified, uncertainty cannot. And it applies to situations in which the world is not well charted.
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Twenty-eight years ago, after years of dreaming and months of training, I booked an overnight journey from Long Island, NY to the fringes of the North Atlantic abyss. The purpose was to dive on the famed Andrea Doria – the Italian luxury liner that rests 200-feet deep on her wounded starboard side, greatly beneath the 130-foot limit of recreational diving. I recall wrestling my arms into the harness of a set of double tanks along with multiple tanks of gas and regulators, lift bags, reels, and instrument consoles...all to spend 25 minutes averaging 200 feet and decompressing for 65 minutes at several stopping points along the oceans dank icebox layer.
The risks of the dive were never-ending and included: Disorientation, entanglement, hopeless visibility, formidable currents, hypercapnia, and death. The uncertainties were visible, but unlike the risks, were subtly vague and better recognized upon reflection. What risk(s) would potentially develop if my confidence bordering on arrogance suddenly broke down or, trusting in my logical assessment of my limitations and belief in my decision-making abilities, fully aware that divers of superior skill have possessed those same beliefs and still perished?
Sketchy records claim roughly 4,500 people have paid homage to the Doria, and of that group 16 perished. If these figures are accurate – that would suggest the risk of dying would be roughly 1:281. However slim the odds, it is the uncertainty of that risk that poses the chief problem. It’s when you realize that neither odds nor the bell curve matter – shivering at 200 feet, they are simply irrelevant. What counts is the ultimate impact to you and your loved ones if you should wind up being lost forever. All choices involve some degree of both risk and uncertainty. Many decisions are made in environments encountered for the first time and, uncertainty flourishes in that quirky relationship between cause and effect.
Given that risk is quantifiable and more accessible to theoretical treatment compared to uncertainty, it should be no surprise literature on financial markets deals specifically with risk. Yet, dismissing uncertainty can prove perilous to the investor.
Observing financial history suggests markets either trend in one direction, like live cattle futures, or revert to some established long-term mean like gold. The billion dollar question of course is, when and over what period of time? This is exactly where uncertainty rears its head – where most of the financial industry is eerily silent or vague. The “what period of time” element is perhaps the only reason the mean-reversion school of thought was born. Uncertainty plays very well in the “when’s” and “what period of times”.
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Imagine the daily variance in your portfolio as an equivalent to watching a train leave the platform from Peekskill, NY and calculating the distance it moves every ten seconds. Initially, say, in the first 10-60 seconds as the train departs, your measurements will be quite accurate, perhaps even to the nearest foot. Then, as the train recedes farther and farther away from you, the preciseness of your measurement will begin to fail. This is due to the increased distance between you and the train, elevation, speed, turns and other physical distortions. It’s what gives contour to that otherwise perfectly normal shaped distribution curve. It’s mathematics best attempt to account for uncertainty.
History has shown the market can deliver large surprises on both the upside and downside. Relevant examples include technological innovations nobody could have imagined earlier, or great ideas that improve efficiency or lower cost. In 1839 Charles Goodyear declared personal bankruptcy in his demoralizing search for a process to cure rubber. If Goodyear had been influenced by the statistical probability of eventually making this discovery, one could assume that the rubber-curing process would not have been implemented until far in the future. Likewise, Thomas Edison’s relentless efforts to develop a workable light bulb might have been significantly dampened by a realistic assessment of probability. It’s possible during all his years of labor, Edison never knew for sure whether his experiments would ever pay off.
By contrast, investors are inundated with risk impressions – philosophies that make the average New Jersey dinner menu look sullenly costive; the investment coaches, blogs, hotel seminars, and half-baked headlines for gold’s drop today when, if the truth were known, that exact headline explained why gold went up the week before! We wind up running barefoot over hot sand and our safety is purely in our speed. We can’t slow down to think and, if we did, it would have dire consequences. In investing, probabilities don’t matter. In fact you could argue the idea of probability doesn’t really make sense. In the end it matters little whether an event has a 1% or a 99% change of happening. Whether or not the incident actually happens and the ultimate payoff or loss is what counts. To be diversified we must look beyond risk and embrace that the world is profoundly complex – at least to the extent that observations of past events offer little guidance for the future.