Recognizing Uncertainty, But Managing Risk

These are the times that make one aware of the consequences of uncertainty. As we have already seen dramatically demonstrated in the past year’s financial crises, uncertainty stymies decision-making, paralyzes investors and freezes markets.

But risk, that’s something else. These are the times to be thankful for those mathematical geniuses Blaise Pascal and Pierre de Fermat, and their successors, who developed the modern concept of risk. Rooted in our numbering system, risk as we have come to understand it provides a framework for seeing the possible consequences of financial decisions.

Thanks, Guys

We all use or are affected by the concept of risk every day. And it helps us understand that the future may resemble the past, but is not destined to replicate it. Now, the weakness of math-based formulas for risk is that they don’t take into account human nature—with all its emotional, non-rational components. The last 18 months are proof of that. As investors and consumers, we have taken a blow, and our subsequent financial behavior will show it.

But we also know that taking a risk, with an understanding of the chance of success or failure, has led to the greatest human endeavors. Putting a man on the moon was full of risk. But think of how it has expanded the scope of possibilities. Finding a cure for disease involves risk, but we are better for it. Pioneers in many fields have risked careers, money, name, and credibility for the sake of an unknown. We are often better for it. As one historian of risk writes, “Given all of its pitfalls, the free economy, with choice at its center, has brought humanity unparalleled access to the good things in life.”¹

Reconsidering Risk

My point is, in times like these we often give risk an undeserved, blanket bad rap. We all know about past market and economic catastrophes. The problem for most of us is that they don’t register until one bites us. In the past year one did, but then many of us have been afflicted with terminal uniqueness, thinking that what we are experiencing has never happened before. Of course what seems at the moment unique and individual is, in retrospect, completely typical.

In times of great market tumult and economic stress we often blur the distinction between risk and uncertainty… to our detriment. Risk implies a situation where you have a sense of the range and likelihood of possible outcomes. Uncertainty, on the other hand, describes a situation where it’s not even clear what might happen, let alone how likely the possible outcomes are.

Risk, managed, is not an enemy to well-being. Most of us are usually okay with taking some amount of risk in investing. We know that corporate bonds are riskier than U.S. Treasury bills, that stocks are riskier than corporate bonds, that small stocks are riskier than large stocks, and so forth. Sometimes it does make sense not to ‘risk it’, of course. But when we confuse risk with uncertainty, we too often choose to “sit this one out” as investors. Regardless of how crazy the past year has seemed, all investing is not now equally risky. Confusing risk with uncertainty in the short term—easy to do when information is kept from you or quickly changes—can foster poor decisions for the long term.

Right now you may feel less confident about financial decisions than at any other time in your investment history. That’s natural. You now may be nervous that if you make wrong choices, you’ll sink the boat, wrecking your financial life with a bad bet. But (leaving aside the inadvisability of a single “bet”) if you do nothing, you could end up missing the boat, letting favorable opportunities pass. Managing risk, instead, can reduce the danger of sinking and increase the likelihood of a safe, rewarding passage. continued

The Skinny

In short, we don’t know how the future will look, but it’s not completely uncertain. Here’s what I am keeping in mind as I navigate clients through the near-term environment.

The record of the past is not a perfect guide, but it is important to informed decision-making.

Risk has degrees: all risk isn’t the same, nor is it equal for all of us.

More info is better, but no amount removes all risk. Even inaction can hold risk.

But risk is usually commensurate with reward.

Spreading risk, as in broad allocation strategies, helps limit it over long periods of time. So it’s important to know the market environment for investment risk, know your personal tolerance for risk and invest accordingly, with the particular financial goals in mind. Accepting, and managing, some degree of risk can keep disappointing results from turning into unrecoverable losses, and open the way to benefits in the long run.

¹Peter L. Bernstein, Against the Gods: the Remarkable Story of Risk. This and another favorite book about risk, Pascal’s Wager, by James A. Connor, have enjoyably informed my reflections on the subject.