Uncertainty is built into every complex system. It’s open-ended. It’s unpredictable.
We face uncertainty when the data we base decisions on only looks backward. This is the crux of investing and why so many great investors have shared thoughts on handling uncertainty.
All the historical market data in the world tells us little about what lies ahead. That’s not to say historical data is useless. It’s…incomplete. We can learn how past events played out, how people reacted to those events, and use that to inform our decisions.
The downside is that history makes things appear predictable. Hindsight makes it easy to explain past events in a tidy way that eliminates the uncertainty and randomness that prevailed at every moment. What happened was bound to happen. The outcome was all but certain. That thought process leads to overconfidence in our ability to predict future outcomes.
Of course, businesses emerged over a century ago within finance to fill the need for certainty. They turned hindsight into a convincing story about the future. Today, forecasters, modelers, and charlatans abound with predictions for markets, the economy, and everything else. When they’re right, they’re praised. When they’re wrong — they usually are — people ignore that they are wrong and listen anyway.
The risk is in listening. It’s better to embrace uncertainty than believe some fortune teller has the future figured out.
The solution starts with diversification. Every investment decision has a range of outcomes. Some are knowable, some not. The best we can do is focus on what we know: figure out the best and worst case for each investment, where the most likely outcome falls in that range, and assess whether that most likely outcome is worth the risk — knowing that it’s not guaranteed.
No other question matters more in an uncertain world than: are you comfortable with the consequences if you’re wrong? It’s the heart of risk management. You don’t bet the ranch on uncertain outcomes. You spread your bets. You diversify.
Your odds of going broke are significantly reduced when you own a basket of businesses (stocks). Those odds are further reduced when you add bonds and other assets to the mix. That’s a process you can control. And in markets where anything can happen, a good investment process is the difference between surviving and going bust.
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Both the business cycle as we usually think of it and the longer-term variations in business activity reflect the alternating domination of first, the genius, then the devil. When the rewards to risk and enterprise appear large, businessmen walk the earth with pride, boast about the superiority of our system, take excessive risks, and consequently tend to forget the inevitable uncertainty of outcomes in an unplanned system. When reality dawns and depression sets in, they hang their heads in shame and, obsessed with uncertainty, tend to forget the rich rewards that the system will pay to those with a spirit of enterprise and an appetite for risk. — Peter Bernstein
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Too many investors fail to follow some simple, time-tested tenets that improve the odds of achieving success and, at the same time, reduce the anxiety naturally associated with an uncertain undertaking. — Arthur Zeikel
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Equilibrium applies best only to markets that deal with known quantities. But financial markets deal with quantities that are not only largely unknown but unkownable. — George Soros
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The most important “first principle” is that time and uncertainty are the central focus of all investment decisions, in the real economy as well as in financial markets. They shape the way in which we value assets and then trade them back and forth with one another. — Peter Bernstein
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We use the term risk all too casually, and the term uncertainty all too rarely. — John Bogle
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Businessmen play a mixed game of skill and chance, the average results of which to the players are not known by those who take a hand. — John Maynard Keynes
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While we can learn from the long run about how bonds and stocks respond to changing environments and to each other, the long run can tell us perilously little about what kinds of environments lie ahead. On that point, I maintain, we have to accept uncertainty rather than fighting it: we must rely more on judgment than on economic models. I agree with Nobel Laureate Kenneth Arrow that “Our knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness. Vast ills have followed a belief in certainty.” — Peter Bernstein
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Uncertainty actually is the friend of the buyer of long-term values. — Warren Buffett
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In investing, nothing is certain. The best investments we have ever made, that in retrospect seem like free money, seemed not at all that way when we made them. — Seth Klarman
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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. — Peter Bernstein
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I think that we only get estimates of the distributions and that we can only be somewhat sure of the estimates. That makes the problems in the financial world much more difficult, I think, because you have these uncertainties in the distributions. — Edward Thorp
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As long as you realize that nothing is sure to happen in this business, every irrationality can be exceeded, that means that you should try to bullet proof your affairs so that it may be likely to happen, but you want to be able to last long enough so that you’re around when it happens. — Howard Marks
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Outcomes are uncertain, but we have some control over what is going to happen or at least some control over the consequences of what does happen. That is what risk management is all about. — Peter Bernstein
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What you really want to do in investments is figure out what’s important and knowable. If it’s unimportant or unknowable, you forget about it. — Warren Buffett
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The applicability of history almost always appears after the event. When it is all over, we can quote chapter and verse to demonstrate why what happened was bound to happen because it had happened before. This is not really very helpful. The Danish philosopher, Kirkegaard, made the statement that life can only be judged backwards, but it must be lived forward. That certainly is true with respect to our experiences in the stock market.
Yet, I think that a knowledge of history — general history, financial history, stock market history — will be found useful for a broad perspective in planning one’s course, even though it may create uncertainty and humility rather than cocksureness with respect to the immediate future. — Benjamin Graham
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You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse. — Seth Klarman
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It’s not uncertainty as such that bothers us, but unknowledge. As John Maynard Keynes once said, “We simply do not know.” Therefore, surprise is inevitable. And when it happens it tells us that the system that we thought we understood (and surprise can happen in many areas of life) is showing signs of instability. — Peter Bernstein
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The future is genuinely uncertain, and therefore cannot be predicted with the same degree of certainty as it can be explained in retrospect. — George Soros
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Financial markets, then, are volatile and unpredictable. Importantly, the markets themselves are far more volatile than the underlying businesses that they represent, which collectively account for their aggregate market capitalization. Put another way, investors are more volatile than investments. — John Bogle
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Most of the outstanding investors that I have known over the years belong to the “I don’t know” school with regard to the macro environment. They may know companies and securities better than anybody else in the world, but with regard to the macro they assume that they don’t know what the future holds. So they hedge against uncertainty. They diversify. They avoid or limit leverage, and they emphasize the avoidance of losses rather than – or I would say as least as important as – the acquisition of gains. — Howard Marks
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The most important lesson an investor can learn is to be dispassionate when confronted by unexpected and unfavorable outcomes. — Peter Bernstein
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A great quote to help us understand the real essence of risk comes from Elroy Dimson, who is a professor at the London Business School. He says, “Risk means more things can happen than will happen.” It is not standard deviation. It is not variability. It is this sense that the future events are highly variable and unknowable that gives us the best sense for risk. — Howard Marks
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I’m in the insurance business, and anything that can happen will happen. — Warren Buffett
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The pernicious effect of hindsight is that we get the sense, after the fact, that an event was predictable, so we get the sense that the world is predictable. We think the world makes sense, and that exaggeration of the coherence, consistency and predictability of the world means that we deny the real uncertainty with which we are faced in existence. And this denial of uncertainty in turn produces irrational action. — Daniel Kahneman
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The investor must recognize that there are uncertain and hence speculative elements inherent in any policy he follows — even an all-Government-bond program. He must deal with these uncertainties by a policy of continuous compromise between bonds and common stocks, and by adequate diversification… Most important, he must maintain a philosophical attitude towards the inescapable variations in his financial position and the inevitable “mistakes” associated with these variations. — Benjamin Graham
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The greatest tragedies occur when people forget about uncertainty. — Peter Bernstein
Related Reads:
Wise Words on Risk Management
Wise Words on Investor Behavior