Risk and Uncertainty

Risk and uncertainty are two different things and distinguishing between the two may help you be a better investor.

We can think of risk as a random outcome that has a known probability distribution while uncertainty has a random outcome with an unknowable probability distribution, according to economist Frank Knight.

For example, playing blackjack is risky because the outcome on any single hand is random, but it still has a known probability distribution. Conversely, dropping a bomb on North Korea would create uncertainty because we have no way of applying a probability distribution to the outcome of that action.

Investing appears to contain aspects of both risk and uncertainty.

From a risk standpoint, we have many decades of historical performance and statisticians can easily develop all kinds of probability distributions for expected returns and standard deviations.

From an uncertainty standpoint, we have days like October 19, 1987, when the Dow Jones Industrial Average dropped 22.6%. That record drop was effectively outside the practical bound of any probability distribution.

Okay, so what are you supposed to do with the knowledge that investing contains elements of risk and uncertainty?

Here are two thoughts.

First, don’t be overconfident. While you may take some comfort that historical probability distributions can show you what to expect in the future, don’t get too confident in that idea. Past performance is no indicator of future results because we have the uncertainty of unexpected events like the October 1987 crash or even the current bear market.
Second, like playing poker, use the odds to your advantage. The market is down about 50% from its all-time high. As long as you believe we’re not at the end of the world, then one could argue that the market is a lot cheaper today than it was in October 2007. So, your odds of making a profit from today’s market level may be greater than they were back then.

With the right understanding, we may be able to turn risk and uncertainty into allies instead of enemies.

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