Only for the most part is the often missing addendum to broad sweeping statements about investing. Things like “stocks outperform bonds” or “value beats growth” typically leave out the closing refrain…only for the most part.
It may not seem important but as Peter Bernstein points out: “If it were ‘always’ rather than ‘for the most part,’ there would be no uncertainty.”
As much as people crave certainty in investing they’ll never achieve always (they’ll never stop looking for it either). Despite that, market history is filled with brief periods where investors purported always was achieved.
That Bernstein quote is from a paper that began as a speech given in September 1999. For those not investing at the time, it was the beginning of the end of a wild ride.
Back then, risk got flipped on its head. The risk was missing out. Stocks — Dotcom stocks especially — achieved always…or so people thought. And anyone who disagreed was labeled an old, out of touch, idiot. Buying into stories of unlimited potential returns do that to people.
Bernstein had more to say on risk and uncertainty, which I share for two reasons. The first is how Bernstein frames asset allocation decisions based on a question that never gets asked enough — What if I’m wrong? Risk management requires mastering that question. The second is his explanation of the source of uncertainty.
Risk is about how we make decisions, and only incidentally about the math that we employ to reach those decisions. Knowing how it works is just the beginning. Knowing how to use these tools is the introduction to wisdom. And that is no easy task.
At its roots, risk is about mystery. It focuses on the unknown, for there would be no such thing as risk if everything were known.
Is the long run risky for stocks or not risky? … As Pascal reminds us, reason cannot tell us what is going to happen on the Day of Judgment. As Keynes so wisely put it in referring to the long run, we simply do not know. If you do not know, you have no choice but to base your asset allocation decisions on the consequences of choosing the wrong allocation. Suppose you put, say, only 60% of your portfolio in stocks and 40% in bonds because you bet that stocks are in fact risky over the long run. Suppose you are wrong. Your fortune will still grow over time as stocks continue to work their miracles over the long run, even if not to the sky. But suppose you put 100% of your portfolio into stocks because you bet that stocks are less risky over the long run. Now suppose you are wrong. Good bye!
The return of events — a replay of the patterns of the past seventy-five years of capital market history — will happen only for the most part. Most is not all. There is no certainty. Rational people do not bet the ranch on a model…that works out only for the most part. And God forbid it works out only for the minor part! Consequences, not probabilities, determine the decisions that matter. Diversification is still the optimal strategy for the long run.
But where does all this uncertainty come from? The answer to that question, above all others, should determine how we manage risk and how we make decisions. In the old days, when most economic activity consisted of hunting, fishing, and agriculture, the weather was the only source of economic uncertainty. You cannot do anything about the weather. Consequently, people depended on prayer and incantation, in one form of another, as the only available form of risk management. What other approach could you take when everything seemed to be God’s will or the will of the Fates?
As we move toward modern times, nature has declining importance. What takes its place? It is at this point that I would propose John von Neumann as the star among the heroes of Against the Gods. The most significant insight in the theory of games was to recognize that men and women are not Robinson Crusoes — each individual isolated from all other individuals. Failure to keep this distinction in mind is the primary reason that the techniques and concepts of the natural sciences so often lead the social scientists astray.
Before von Neumann, the development of decision theory by innovators like Pascal and Daniel Bernoulli visualized each individual making choices that had no effect on any other individual’s range of choices. They calculate their utilities in the privacy of their own rooms. That concept is totally artificial. No man is an island…
All economic systems, even the most primitive, depend on production and technology, but capitalism is about buying and selling even more than it is about production and technology — it is a giant von Neumann game! Buying and selling means human decisions: What will the customer decide? What will the supplier decide? What will the employee decide? What will the politicians decide? The process is intensively interactive. The enemy is us. The decisions that each of us makes as we ask ourselves these questions will, in turn, have an influence on how customers, suppliers, employees, and politicians will make their choices in response to ours. In the end, the value of your portfolio is not what somebody tells you is likely to happen over the long run but how much other investors out there are going to be willing to pay you for your assets.
Game theory teaches us that human beings create a complex jumble of uncertainties for one another. It is not enough to say that human nature never changes and let it go at that. Human beings learn from experience and learn from technology. Yesterday’s response to a given set of circumstances is only a hint of what tomorrow’s response to that set of circumstances will be — and in any case Leibniz reminds us that today’s circumstances will reappear tomorrow, not precisely, but only for the most part. So we really do not know what the future holds. Risk in our world is nothing more than uncertainty about the decisions that other human beings are going to make and how we can best respond to those decisions.
Facing the Consequences – Peter L. Bernstein
- Predicting the Future with Bayes’s Theorem – Farnam Street
- Notes From the Road: Roadkill – Epsilon Theory
- Fool Me Three Times and I Give Up – M. Housel
- Siegel vs. Shiller: Is the Stock Market Overvalued? – Wharton
- Could Simple be the New Complex? – ValIdea
- The Holy Active Empire – Medium
- The Mind of an Anthill – Knowable
- Absolute Success is Luck. Relative Success is Hard Work – J. Clear
- The European Union Versus the Internet – Stratechery
- The Oral History of Apple’s Infinite Loop – Wired
- The Untold Stories of Paul McCartney – GQ