"There are known knowns; there are things we know we know.
We also know there are known unknowns; that is to say we know there are some things we do not know.
But there are also unknown unknowns -- the ones we don't know we don't know."
-- Donald Rumsfeld, Former US Secretary of Defense
As the years have rolled on, I've come to realize that the most important factors in investing are not earnings, revenues, economic growth, or interest rates. No, the most important variable in investing is how humans will react to all those other variables. Will they be positively or negatively surprised, or will events unfold just as they expected? Sometimes stocks move dramatically when earnings are announced, and the results surprise investors. Other times, the earnings were just what was expected, and the stock hardly moves at all (the news was priced in).
Managing a portfolio is about protecting that portfolio from known unknowns, and unknown unknowns. A known unknown is something that you know has happened in the past and has a high probability of occurring again. You just don't know when it may occur. Known unknowns could be cyclical recessions, inflation, deflation, or interest rate movements. Since we know these events will probably occur in the future we can build a diversified portfolio and vigilantly move our assets to be in harmony with the markets.
Unknown unknowns are the real game changers. Since we don't know what the risk is, or where it may come from, it is very difficult to prepare and protect. This is also called tail-risk or black swans. The recent earthquake and tsunami in Japan, as well as the developing nuclear crisis, are an excellent example of tail-risk. Similar comparisons are being made with the BP Gulf oil disaster, Chernobyl, and even the financial crisis of 2008. It appears that the engineers designing Japan's nuclear reactors accounted for the fact that they were building on a fault line, but underestimated the cascading unknowns of a massive tsunami. Avoiding unknown risks is a tricky business, and sometimes simply impossible.
Known events don't surprise us, and subsequently don't move markets. Known unknowns surprise us in their timing, and therefore have an impact on markets that varies with their magnitude. Unknown unknowns always surprise, and again depending on their magnitude, the impact on markets will vary. For the unfortunate people in northern Japan the magnitude of this weekends events is crushing. For the rest of us it serves as another example of the need to be prepared.
We can only go so far in preparing for unknown events. Eliminating all risks, known and unknown, is virtually impossible, and often comes at an unconscionable cost. Say you want to avoid accidental death. Don't drive, or cross the street, or light a gas grill, or live on a planet subject to earthquakes, hurricanes, or the occasional life destroying asteroid. Life is full of risks, for every financial return we generate we've assumed a certain amount of risk. Some of those risks may be larger than what we initially bargained for.
One of the quirks in the human psyche is that we react much more powerfully to negative surprises than we do to positive surprises. There have been numerous scientific studies that attempt to measure the magnitude of our risk avoidance. A famous experiment done in the 1970's by psychologists Daniel Kahneman and Amos Tversky asked students to bet on coin flips. If the coin landed on heads, the students had to pay the professors $20. If it landed on tails the professors would pay the students. What the professors wanted to know was how much they would need to pay the students, to entice them to make the bet. Would the students accept $21 for tails? How about $25?
If the students acted in a rational manner they would accept any amount greater than $20 to make the bet. The risk/reward is a known 50%-50% bet. Anything that tilts the payout in their favor should be accepted. Surprisingly the professors found that the students demanded nearly a $40 payout to accept the risk of losing $20. Psychologists have subsequently determined that humans are nearly twice as sensitive to the pain of loss as they are to the pleasure of gain. Even studies of married couples has found that every negative comment made by a spouse requires at least five complements as compensation. Rewards are nice, but pain lingers.
This pain avoidance is a powerful force in how people invest. They are biased to exaggerating bad news and avoiding perceived risk at great cost.
Fear of the unknown is why so many overpay for insurance products. Better safe than sorry, right? Understanding the probability of the risk, and the costs of protection are critical to managing a portfolio. The probability of the US dollar no longer being the worlds reserve currency may be rather low, but the magnitude of that risk coming to fruition could be devastating. If everything you own, including your salary, was all of a sudden worth 25% less, would that have a negative impact on your living standards?
We are always faced with the risk of loss, both physical and financial. It is imperative that we try and understand the probabilities, the potential magnitude, and the costs associated with protection. A healthy balance is essential. Unknowns, tail-risk, can never be fully avoided or even reduced at a tolerable cost. The existence of this inescapable risk teaches us to live life now, while it is still within our grasp.
"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."
--Mark Twain
Be careful out there, and keep the lights on,
Chris Wiles, CFA
412-260-7917
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This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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