Investing is all about the future. We invest cash today with an expected but ultimately uncertain amount of cash to be received in the future. The problem with the future is it’s largely unpredictable. Sure, we do our best to estimate and forecast what will happen, but ultimately, we invest in unknown and uncertain environments.
In a 2006 paper, Investing in the Unknown and Unknowable, Richard Zeckhauser described the challenges and opportunities of investing in unknown and unknowable environments. It’s a powerful article that explains why:
1. Investors are overconfident in their ability to predict the future.
2. Investors are reactionary and respond poorly to uncertainty and ambiguity.
3. Investors should view the unknown as an opportunity, not a threat.
An uncertain future isn’t predictable, but we can prepare. Major investing mistakes occur at the extremes – whether a deep financial crisis or unconstrained market highs. Ambiguous and uncertain environments magnify poor decisions. These environments cause us to lose our rational, logical thoughts and rely on our primal, reactionary mental instincts. They goal is to understand how our mind reacts to unknown situations and design ways to turn these situations into opportunity. In essence, we should focus on preparing for uncertainty, not predicting uncertainty.
Investors should consider the following six lessons to help reframe unknown environments from fear to opportunity. As Richard stated, “Though investments are the ultimate interest, the focus of the analysis is how to deal with the unknown and unknowable.” Understanding the basics of the unknown allows us to make better decisions with less mental anguish. This can apply beyond investing to everyday life.
Principle #1: Understand When Traditional Financial Theory Fails
The essence of effective investment is to select assets that will fare well when future states of the world become known. When the probabilities of future states of assets are known, as the efficient markets hypothesis posits, wise investing involves solving a sophisticated optimization problem. Of course, such probabilities are often unknown, banishing us from the world of the capital asset pricing model (CAPM), and thrusting us into the world of uncertainty.
The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance. -Zeckhauser’s Investing in the Unknown and Unknowable.
Traditional financial theories work well in normal environments, but break down at the extremes. It’s our preparation for extremes that enables us to navigate uncertain waters. Proper investing at extremes has more to do with emotional intelligence than financial expertise. It’s about making gut-wrenching decisions during financial chaos or irrational optimism. In theory, you should be following the same basic prudent investing rules regardless of the environment: rebalancing to your target portfolio, managing your liquidity and cash flows, and examining your risk profile. In a crisis, prudent behavior disappears as typical financial relationships break down. Our decision making becomes a random assortment of knee-jerk reactions and emotionally-fueled urges.
The practical solution is to first accept these situations will occur. Don’t stick your head in the sand. We can’t predict the causes or magnitudes of extreme events. But while prediction fails, preparation advances. We can prepare by understanding the investments we own so we can overcome our emotions and regain long-term, logical thinking. We can run through scenarios and stress our portfolio to extremes to figure out how much pain we can handle.
Finally, we can study historical events and learn lessons from other great investors who went through similar situations. There are two benefits. First, it’s comforting to know the best investors have gone through the same pain and faced the same impossible decisions that we will face. Second, we can actually borrow these investor’s techniques and tools for our own use. Many great investors lay out exactly how they approach unique situations. We can build a library of principles to help guide us during uncertain environments.
The second dreary conclusion is that most investors – whose training, if any, fits a world where states and probabilities are assumed known – have little idea of how to deal with the unknowable. When they recognize its presence, they tend to steer clear, often to protect themselves from sniping by others. But for all but the simplest investments, entanglement is inevitable – and when investors do get entangled they tend to make significant errors. -Zeckhauser’s Investing in the Unknown and Unknowable.
Ignoring the unknown is not an acceptable strategy. Delaying the recognition magnifies future errors. These errors can eliminate years of sound investing during normal times.
Remember the 2009 financial crisis. Investors who had done everything right up until then were caught off guard with the severity of the crisis. Many investors had excessive amounts of risk going into the crisis, and then compounded the problem by going to cash at the bottom. It’s not that investors forgot the basics of investing. It’s that they didn’t prepare for the “entanglements” in advance, so investors weren’t ready to make better choices.
Principle #2: To Capture Excess Investment Returns, Study The Unknown/Unknowable
Such idiosyncratic UU [unknown and unknowable] situations, I argue below, present the greatest potential for significant excess investment returns.
The first positive conclusion is that unknowable situations have been and will be associated with remarkably powerful investment returns. The second positive conclusion is that there are systematic ways to think about unknowable situations. If these ways are followed, they can provide a path to extraordinary expected investment returns. To be sure, some substantial losses are inevitable, and some will be blameworthy after the fact. But the net expected results, even after allowing for risk aversion, will be strongly positive. -Zeckhauser’s Investing in the Unknown and Unknowable.
Exceptional opportunities occur in volatile environments. These unknown and unknowable (Zeckhauser refers to them as “UU”) situations, can deliver significant opportunities. Investors scared of big price moves won’t have the fortitude to handle the occasional misses. Remember, the goal is to grow the total portfolio value over time. How many misses you have isn’t the important variable; it’s the totality and magnitude of your wins and losses that matter. Those who prefer no losses at all, often sacrifice significant total return growth verses investors who can handle some losses but allow their successful investments to more than compensate for those losses.
There is nothing wrong with a conservative, diversified portfolio that avoids higher return/higher risk investment situations. It’s important to understand where you have an advantage and where you don’t.
However, investors who excessively try to avoid volatility and uncertainty often buy and sell at the worst possible times, locking in losses to avoid mental pain.
Do not read on, however, if blame aversion is a prime concern: The world of UU is not for you. Consider this analogy. If in an unknowable world none of your bridges fall down, you are building them too strong. Similarly, if in an unknowable world none of your investment looks foolish after the fact, you are staying too far away from the unknowable. -Zeckhauser’s Investing in the Unknown and Unknowable.
Investors’ excessive desire to avoid looking foolish punishes their future returns. For example, it’s always hard to buy near the bottom since the trend looks so bad and the news flow is negative. And because investors tend buy early, they will certainly look foolish in the short term. This apparent foolishness compounds the already challenge of capturing exceptional opportunities. The ego’s desire to avoid looking wrong in the short term causes huge long-term pain. Short-term, “foolish” decisions can often be the most profitable, because a little early pain is necessary to capture the biggest opportunities.
But it would be surprising not to see significant expected excess returns to investments that have three characteristics addressed in this essay: (1) UU underlying features, (2) complementary capabilities are required to undertake them, so the investments are not available to the general market, and (3) it is unlikely that a party on the other side of the transaction is better informed. That is, UU may well work for you, if you can identify general characteristics of when such investments are desirable, and when not. -Zeckhauser’s Investing in the Unknown and Unknowable.
Let’s examine the 3 characteristics –
1. UU Underlying features – Most UU (again, shorthand for unknown and unknowable) situations are a result of previous excesses being unwound in a rapid fashion. This can be an erosion of asset value at financial institutions (2009 crisis) or a shift in commodity supply & demand causing rapid price declines (2015 oil collapse). There are constant factors leading up to these crises. Easy money in the form of cheap debt or plentiful capital for investment. Excessive enthusiasm. Embracing new valuation paradigms with no substance. These environments begin with reasonableness but end up at extremes due to extrapolation, momentum, inadequate risk consideration, and a disregard for mean reversion and competition. There is usually a claim that this time is different.
2. Complementary Capabilities – These capabilities refer to an investor’s ability to correctly analyze a UU situation. Although there is no guarantee of success, great investors have a few key attributes that convert a UU situation into a wise investment. First, they have the correct mental makeup and behavior regulation that enables logical and emotion-free analysis. Nothing is harder than trying to keep your head when a market is collapsing. Great investors acknowledge the uncertainty and emotion, but quickly engage their higher cognitive powers to establish agency over the situation. Highly complex investments don’t lend themselves to casual analysis by unprepared investors.
Second, they are subject matter experts on the specific market or security. Successful investing is not about blind investing into UU situations. Mean reversion works on average, but there is enough variation around the average which allows investors to blow up their portfolio. You don’t have to become the most knowledgeable and obtain a Ph.D, but you must know enough the tilt the odds in your favor. Not all investments that price at bargain levels will make it, and a few zeros can destroy your portfolio or cause you to lose faith in your process at the moment you need it most.
Finally, successful UU investors focus on risk control. Risk control is not about avoiding risk. Risk control is about thoughtfully approaching your portfolio with a sense of humility that offsets the natural tendency to overinvest or overconcentrate. Humility checks your ego and spreads your risk among several very attractive investments, rather than focus on one or two high conviction names. Well-known investors have been burned by overconfidence in their top ideas. When these go bad, they lose more than they can ever recover. Investing is always uncertain and unpredictable, and overconfidence will trap even the best investors.
3. Information Asymmetry
Investors should pay close attention to the other investors in the market. If the situation favors the other side of the trade because they have an informational advantage, investors will likely lose. In some markets, such as IPOs, M&A transactions, art investing, etc, sophisticated/specialized investors will have a significant advantage. These markets are highly competitive and leave most investors as the sucker. However, UU situations are different. They are avoided because of the psychological pain and uncertain environment. All investors generally have the same informational level.
Principle #3: Judgment, Not Intelligence, Distinguishes Great Investors
Alas, few of us possess the skills to be a real estate developer, venture capitalist or high tech pioneer. But how about becoming a star of ordinary stock investment? For such efforts an ideal complementary skill is unusual judgment. Those who can sensibly determine when to plunge into and when to refrain from UUU investments gain a substantial edge, since mispricing is likely to be severe. -Zeckhauser’s Investing in the Unknown and Unknowable.
Judgement determines whether our investing intelligence is converted into money-making investments. Intelligence needs to be applied to the correct asset, at the correct price, at the correct time. Lots of smart, sophisticated investors execute poorly. For example, they buy good assets at the wrong price. They let emotions and hubris interfere with great thinking and end up buying or selling at the wrong time or in the wrong markets.
Note, by the way, the generosity with which great investors with complementary skills explain their successes – Buffett in his annual reports, Miller at Harvard, and any number of venture capitalists who come to lecture to MBAs. These master investors need not worry about the competition, since few others possess the complementary skills for their types of investments. -Zeckhauser’s Investing in the Unknown and Unknowable.
It’s an interesting thought – does Warren Buffet or other great investors fear giving away their secrets? No. They know the right combination of intelligence, temperance, humility, sound judgment, and courage may take decades to develop. Investors can’t turn on this ability when they want. It’s a mindset that needs deep cultivation and a lifetime of practice.
Principle #4: Overcoming Investor Biases Requires Thoughtful & Deliberate Training
Behavioral decision has important implications for investing in UU situations. When considering our own behavior, we must be extremely careful not to fall prey to the biases and decision traps it chronicles. Almost by definition, UU situations are those where our experience is likely to be limited, where we will not encounter situations similar to other situations that have helped us hone our intuition. -Zeckhauser’s Investing in the Unknown and Unknowable.
UU situations are not won by accumulating more facts or having a bigger spreadsheet. In these environments, there is an irreducible amount of uncertainty, no matter how much work and effort is applied. Clearly, you need to do your homework before investing. But many investors have the false idea that they can get rid of all uncertainty. They fool themselves with blind overconfidence. Our mind’s natural tendency is to eliminate any apparent uncertainty, through the stories we tell ourselves or our selective analytical approaches. UU situations require analysis and work, but ultimately success comes down to making a tough decision when the probability is deeply in your favor.
There are too many investor biases and mistakes to list here, but the important takeaway is to get comfortable with uncertainty. It’s a natural condition of successful investing. The goal is not uncertainty elimination, but uncertainty acceptance and management. If you accept uncertainty, you transform your outlook on uncertainty from a situation to fear to a situation to exploit.
Principal #5: Invest Where Others Neglect
The major fortunes in finance, I would speculate, have been made by people who are effective in dealing with the unknown and unknowable. This will probably be truer still in the future. Given the influx of educated professionals into finance, those who make their living speculating and trading in traditional markets are increasingly up against others who are tremendously bright and tremendously well-informed. -Zeckhauser’s Investing in the Unknown and Unknowable.
Just as in business, it often pays to invest in assets neglected by the competition. Fast growing ideas attract significant capital, reducing the expected returns and raising the risk profile. Investors who are late to the party will end up with higher risk and lower returns. For most investors, they are unlikely to be the first movers or early followers. They will arrive late, invest at the peak, and suffer significant losses.
The antidote is to go where there is less competition, little excitement, and significant uncertainty. These factors drive most investors away and create mispricings as prices significantly deviate from fundamentals.
Even sophisticated investors are likely to shy away from these areas.
First, their clients expect and prefer lower volatility and consistent returns, rather than volatile but higher returns. Clients want a smooth ride, and don’t tolerate excessive volatility from even the best managers.
Second, manager themselves feel pressure to gravitate towards opportunities that have a compelling narrative. Narrative-based investments are an easier sell to internal management and the public because they sound so good and have often performed well. But these attributes don’t correlate with future success, as competition and mean reversion often reverse any positive momentum and derail the narrative.
Finally, investments that appear certain today will often become uncertain, and vice versa. Uncertainty isn’t a permanent characteristic of any particular asset class. Uncertainty ebbs and flows based on investor emotions and economic conditions. Today’s uncertain areas may become more predictable as industries and companies adjust and adapt to new environments.
Because these environments are fluid and dynamic, they are always working toward an equilibrium condition. For example, when companies go bankrupt, those bankruptcies often give the remaining companies a stronger competitive position, higher market share, and a bigger share of the profits. So the conditions that cause uncertainty will usually correct itself as the markets and competitive economies adjust to new realities.
If you understand this process, you can be forward thinking and have a reasonable idea how these industries will evolve, even when it seems that the pain or uncertainty is unmanageable.
By contrast, those who undertake prudent speculations in the unknown will be amply rewarded. Such speculations may include ventures into uncharted areas, where the finance professionals have yet to run their regressions, or may take completely new paths into already well-traveled regions.
Similarly, the more difficult a field is to investigate, the greater will be the unknown and unknowables associated with it, and the greater the expected profits to those who deal sensibly with them. Unknownables can’t be transmuted into sensible guesses -- but one can take one’s positions and array one’s claims so that unknowns and unknowables are mostly allies, not nemeses. And one can train to avoid one’s own behavioral decision tendencies, and to capitalize on those of others. -Zeckhauser’s Investing in the Unknown and Unknowable.
Avoid depending on ultra-precise analysis as an attempt to remove uncertainty. The goal is to get close enough in your understanding of the situation to make an educated guess and position accordingly. Investors comforted by false precision are usually wasting time or fooling themselves.
Principle #6: Bet According To Your Advantage; But First Be Honest About Whether You Really Have An Advantage
…The greater is your expected return on an investment, that is the larger is your advantage, the greater the percentage of your capital you should put at risk…Most investors understand this criterion intuitively, at least once it is pointed out. But they follow it insufficiently if at all. The investment on which they expect a 30% return gets little more funding than the one where they expect to earn 10%. Investment advantage should be as important as diversification concerns in determining how one distributes one’s portfolio. -Zeckhauser’s Investing in the Unknown and Unknowable.
There should be some obvious intuition that higher conviction ideas with less risk and higher expected returns should have bigger positions in your portfolio.
In principle, I agree with that assessment. But there is a major assumption underlying this idea that must be true for this to work:
Do you actually have an advantage?
How do you know?
How do you know if you have correctly analyzed, vetted, and arrived at the correct conclusion?
What if you are just overconfident and mistaken?
How would you know until it’s too late?
Anecdotally, I have heard several investors proclaim an investment as their #1 idea, only to see it actually end up as one of the worst ideas. I don’t believe an investor’s conviction level translates into above average returns. In fact, there may be an inverse correlation between the two. Anyone can pitch a compelling idea that promises all upside and no downside. It doesn’t mean it will happen.
If the difference between two ideas is significant enough, they should have different portfolio weights. But again, this all rests on the ability of the investor to be well calibrated to know when these differences really exist and when they are false.
Summary
Two rays of light creep into this gloomy situation: First, only rarely will his information put you at severe disadvantage. Second, it is extremely unlikely that your counterpart is playing anything close to an optimal strategy. After all, if it is so hard for you to analyze, it can hardly be easy for him. -Zeckhauser’s Investing in the Unknown and Unknowable.
As a final reminder, most investors you compete with are not playing an optimal strategy. Most are struggling, trying to figure out the best move in a complicated and uncertain world. Especially in periods of extreme stress, investors are likely to be on edge, forgetting the basic investing tenants and relying on emotion and gut feeling. By contemplating these principles, you have taken the initial steps to properly execute in the right investment situations. To be sure, you won’t get every decision correct. And yes, you may end up trading across from Warren Buffet or some elite hedge fund. But those situations will be the minority, especially if you adhere to these principles when thinking about the unknown and unknowable.
If you acknowledge and embrace the unknowable, you are better equipped to handle reality as it is – uncertain and unpredictable. By using wise judgement and training to overcome your inherent misconceptions, you outperform competing investors by leveraging your circle of competence and understanding when to make appropriate bets.
The 6 Principles in Review:
Principle #1: Understand When Traditional Financial Theory Fails
Principle #2: To Capture Excess Investment Returns, Study The Unknown/Unknowable
Principle #3: Judgment, Not Intelligence, Distinguishes Great Investors
Principle #4: Overcoming Investor Biases Requires Thoughtful & Deliberate Training
Principal #5: Invest Where Others Neglect
Principle #6: Bet According To Your Advantage; But First Be Honest About Whether You Really Have An Advantage