I have posted on risk previously (here), but while markets are (relatively) calm, I thought I would talk about risk vs. uncertainty.
One of the primary findings from behavioral finance is significant overconfidence in our predictions. Though some of these might be more than you would want to tackle, I highly recommend the following as antidotes to hubris:
- Risk, Uncertainty And Profit (1921) by Frank Knight
- Pearl Harbor: Warning and Decision (1962) by Roberta Wohlstetter (just the forward by Thomas Schelling, 2005 Nobel Memorial Prize in Economic Sciences winner)
- The Psychology of Intelligence Analysis (1999) by Richard Heuer
- The Black Swan: The Impact of the Highly Improbable (2007) and Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (2008) by Nassim Nicholas Taleb
- The Signal and the Noise: Why So Many Predictions Fail – But Some Don’t (2012) by Nate Silver
- Rumsfeld’s Rules: Leadership Lessons in Business, Politics, War, and Life (2013) by Donald Rumsfeld (just chapters 5&6, “Planning for Uncertainty” and “The Unknown Unknowns”)
Frank Knight made a crucial distinction between risk (you know the probability distribution, but don’t know the specific outcome) and uncertainty (you don’t even know the probability distribution). For example you know the probability of rolling a one on a traditional six-sided die is 1/6 – so a roll is risky. But what is the probability of rolling a one on a die specified only as polyhedral? That roll is uncertain.
Donald Rumsfeld pointed out another level of problem with his “unknown unknowns” where you don’t even know that you are uncertain. I.e. you assume something referred to as a “die” has six sides, but in fact it may not.
Despite all this, we can’t simply throw up our hands, we have to make a call for our clients despite the murkiness of the future.
I leave you with some of my favorite quotes on planning and prognosticating:
- “[P]lans are useless, but planning is indispensable.” – Dwight D. Eisenhower
- “Everyone has a plan ’till they get punched in the mouth.” – Mike Tyson
- “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.” or “It ain’t ignorance causes so much trouble; it’s folks knowing so much that ain’t so.” and other variants – variously attributed to Josh Billings, Abraham Lincoln, Will Rogers, and Mark Twain (Josh Billings has the best claim)
- “No plan survives first contact with the enemy.” – Helmuth von Moltke the Elder
- “Prediction is very difficult, especially about the future.” – variously attributed to Niels Bohr, Samuel Goldwyn, Nostradamus, Yogi Berra, Mark Twain, and Will Rogers (but probably an old Danish saying)
- “The inevitable never happens. It is the unexpected always.” – John Maynard Keynes
- “The unexpected is the prince of the battlefield.” – Carl von Clausewitz
- “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.” – Donald Rumsfeld
- “Those who know, don’t talk. Those who talk, don’t know.” – Lao Tzu
- “To be absolutely certain about something, one must know everything or nothing about it.” – Olin Miller
- “When the number of factors coming into play in a phenomenological complex is too large, scientific method in most cases fails. One need only think of the weather, in which case the prediction even for a few days ahead is impossible.” ― Albert Einstein
- “When you know a thing, to hold that you know it; and when you do not know a thing, to allow that you do not know it; this is knowledge.” – Confucius