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Wednesday 16 July 2014

U is for Uncertainty

Uncertainty is the reality of the unknown unknowns. We don't know what we don't know: we can't even measure it. And we don't like it, not at all. In fact we don't like it so much we're prepared to ignore it, which is unfortunate as it's an 800 pound gorilla sitting in the corner. Painted blue, wearing a tutu and playing a bassoon.

We really hate uncertainty.


The classic example is known as Ellsberg's Ambiguity Paradox. You have two urns (*),  urn A containing equal numbers of red and black balls and urn B containing random numbers of the same. When asked to choose color and urn most people stick their hand in urn A to grab a ball where they have a  definite 50/50 chance of being right. However, if they choose A and red this means they think there are less red balls in urn B. Which means there are more black balls in urn B. Which means you should have chosen black and B. Hence it's a paradox.

Statistically you have exactly the same chance of being correct with both urns, but urn A offers certain odds while urn B offers uncertain ones - and our aversion to uncertainty kicks in. And as the stockmarket has a nasty tendency to morph from urn A to urn B overnight it's frequently beset by panicked investors who've suddenly re-discovered the chilling power of uncertainty.


We prefer known risks to unknown uncertainty, because we can't cope with uncertainty - and it drives us to do stupid things like trying to assert control when we can't - aka the illusion of control. When we're finally confronted with uncertainty we tend to panic, and this is when we sell our stocks regardless of price, such is the mental distress that it causes. Even worse, we try to put the whole nasty episode out of our minds as soon as possible - which then leads to myopia where we forget the lessons of the past incredibly quickly and proceed to make the same mistakes all over again.


We're not built to handle uncertainty so learning to deal with it is difficult - but essential, because markets are full of the stuff. Uncertainty is why no one can really predict anything very much in the short-term and why we need to operate on the basis that something bad is quite likely to happen quite soon.

Learning from history is critical, but investing in things which can stand the test of time and which can ride out uncertainty is probably the best defense you can ever build. If you want to make money quickly in the markets then you will need to take your chances with urn B, but if you can take a long-term view then absent the end of the world uncertainty should hold no fears. At some point you'll lose 20% or more of your portfolio value more or less instantly; the question is whether you can cope with it, or not.

(*) Economists just love urns. Presumably it sounds more stylish than "bucket"?

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