Risk and Uncertainty and Heuristics

riskI’ve become very attached to the “Five Year Rule,” which is my consistent rule-of-thumb answer to the question: Should I invest in stocks?

Five Year Rule

How does the Five Year Rule work? I answer the “should I invest question” with a question of my own.

Will you need the money in less than five years? If yes, then you can’t invest in stocks.

If no, then you should invest in stocks. It’s that simple.

I find this works better than more sophisticated approaches precisely because the stock market is just too darned uncertain for my little brain to comprehend.

A Risky World

Donald RumsfeldFormer Defense Secretary Donald Rumsfeld infamously quipped

“There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say, we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.”

And although this sounded at the time nearly like a particularly strangled Dr. Seuss poem, and Rumsfeld stated it at a difficult point in the lead-up to the 2003 Iraq War, he had a point there.

Despite the guffaws at Rumsfeld and the catastrophe of that particular war, as an epistemological statement, I’d like to offer my thumbs-up to Rumsfeld.

A simpler but similar phrase – often attributed to Mark Twain – goes like this:

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

We all need better ways of sorting through what we know and what we don’t know, We need help with risky and uncertain situations.

Risk Savvy

I recently finished a book called Risk Savvy by Gerd Gigerenzer, a theoretician of decision-making who provided some of the research behind Malcom Gladwell’s better-known book Blink.

Although I don’t recommend Risk Savvy overall, Gigerenzer makes in important distinction between situations involving “risk” and other situations involving “uncertainty.”

Risk vs. Uncertainty

Decisions involving risk, I understand, are ones in which we try to reasonably calculate the chances for success or failure based on a set of known probabilities, and we act accordingly. My regular poker game with the neighborhood dads follows the logic of “risk” decision-making. I put my $20 into the kitty, and then I place bets based on reasonable guesses about what cards may fall and what my fellow players hold in their hands.

Risk management in this situation has to do with calculating odds, placing appropriate-sized bets (and also possibly limiting my alcohol intake.) I find this enjoyable, and to a degree, easily-managed risk.

Incidentally, to give you a sense of my poker track record, my youngest daughter collectively calls the neighborhood dads “the bad men who take Daddy’s money.”

The uncertainty of this situation, in the Gigerenzer sense, however, is distinct from the risk. It arises not from the cards, probabilities, and bets but rather from the chance that one of the neighborhood dads suffers a psychotic break and decides tonight is the night to upturn the table, grab the kitty full of twenties, and make a mad dash for the Mexican border.

poker_riskThat hasn’t happened yet, thankfully. But it would certainly fall outside the expected risks I thought I was taking when I showed up on any given Sunday night. “Uncertainty” in my example arises from risks I didn’t know I was taking. In a Rumsfeldian sense that neighborhood dad making a run for the border might be an “unknown unknown.” It’s hard to plan for that kind of thing.

Back to Stocks

As a student of the markets, I believe deep skepticism about whether we understand the risks we take is extremely helpful to keep top of mind.

We can approach a risky situation like the stock market, for example, with a scientific risk-management mindset. We try to solve the (known) unknowns. We calculate a firm’s past profits and model an estimate of its future profits. We estimate the effect of changes in interest rates and exchange rates. Growth curves. Technological changes. Management styles. Marketing strategies. Competitor analysis. Insider holdings. This is the stuff of the business section of all newspapers, magazines, television shows and blogs. All of these are known risks for any individual company and therefore any individual stock investment. And I would argue, deep knowledge of each and all of these risks might be nice, but sadly still leave you with woefully incomplete information. You still haven’t covered all the uncertainty.

No risk models in the world prepare you for commercial airlines to hit towers in a clear blue sky day in New York City. The model still won’t warn you about the following month, when Fortune Magazine’s winner of “America’s most Innovative Company” – 6 years in a row – will evaporate $74 Billion in shareholder value (Enron.) Or that that same month of October 2001 a product launch (iPod) by a tired, has-been tech company (Apple), is the key first step toward its future as the most valuable stock in the world.

Two faulty approaches we humans take in the face of all this uncertainty are 1. To avoid the uncertainty altogether and 2. To build increasingly complex models.

Avoiding the stock market altogether would be a shame since it’s one of the best tools for slowly building wealth over a lifetime.

Gigerenzer, the author of Risk Savvy, offers a helpful corrective to the traditional risk-management style of building increasingly complex models for calculating all the risks.

Hueristics

Gigerenzer’s advice is to substitute simple heuristics – also known as “rules of thumb” – to give you pretty good results in the face of extreme uncertainty.

Without knowing it, long before I read Gigerenzer, I’ve been cleverly substituting my Five Year Rule for all that fancy financial modeling. Not only are the market risks incalculable, the unknowns are really just too great. We probably don’t even know the things we don’t know.

The thing I can control, and that I do know, is whether I’ll need my money back within five years. If yes, I don’t put it in the stock market.

If I don’t need the money, well then, cowboy up!

A version of this ran in the San Antonio Express News

Please see related post

 

Book Review of Risk Savvy by Gird Gigerenzer

 

 

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