Risk, Uncertainty and Ignorance in Investing and Business – Lessons from Richard Zeckhauser

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Richard Zeckhauser is an American economist and a Professor of Political Economy at the Kennedy School at Harvard University. Charlie Munger has said about him: “The right way to think is the way [Harvard Professor Richard] Zeckhauser plays bridge. It’s just that simple.” “Smart people make these terrible boners. …Well maybe a great bridge player like Zeckhauser [doesn’t], but that’s a trained response. The list of his published work is long. That work reveals that he is a polymath interested in many things. He has won multiple national championships in contract bridge.

• “People feel that 50% is magical and they don’t like to do things where they don’t have 50% odds. I know that is not a good idea, so I am willing to make some bets where you say it is 20% likely to work but you get a big pay-off if it works, and only has a small cost if it does not. I will take that gamble. Most successful investments in new companies are where the odds are against you but, if you succeed, you will succeed in a big way.” “David Ricardo made a fortune buying bonds from the British government four days in advance of the Battle of Waterloo. He was not a military analyst, and even if he were, he had no basis to compute the odds of Napoleon’s defeat or victory, or hard-to-identify ambiguous outcomes. Thus, he was investing in the unknown and the unknowable. Still, he knew that competition was thin, that the seller was eager, and that his windfall pounds should Napoleon lose would be worth much more than the pounds he’d lose should Napoleon win. Ricardo knew a good bet when he saw it.”

I started with the two quotes above to lure you in to learning more about Zeckhauser’s ideas. His advice is very practical even though it is academically grounded. Once you learn his methodology, it will be broadly applicable in your life. You can’t “unsee” what he teaches which is a very good thing. In part of this quotation immediately above Zeckhauser is describing what Michael Mauboussin calls “The Babe Ruth Effect.” Mauboussin writes:

“…in any probabilistic exercise: the frequency of correctness does not matter; it is the magnitude of correctness that matters…. even though Ruth struck out a lot, he was one of baseball’s greatest hitters…. Internalizing this lesson, on the other hand, is difficult because it runs against human nature in a very fundamental way.”

Venture capital is a classic example of a business that profits from the Babe Ruth effect. Chris Dixon writes in a blog post:

“The Babe Ruth effect is hard to internalize because people are generally predisposed to avoid losses. …What is interesting and perhaps surprising is that the great funds lose money more often than good funds do. The best VCs funds truly do exemplify the Babe Ruth effect: they swing hard, and either hit big or miss big. You can’t have grand slams without a lot of strikeouts.”

There are many other situations in like that involve a big upside and a small downside. They are in fact common, if you know where to look and how to find them.

• “Risk, which is a situation where probabilities are well defined, is much less important than uncertainty. Casinos, which rely on dice, cards and mechanical devices, and insurance companies, blessed with vast stockpiles of data, have good reason to think about risk. But most of us have to worry about risk only if we are foolish enough to dally at those casinos or to buy lottery cards….” “Uncertainty, not risk, is the difficulty regularly before us. That is, we can identify the states of the world, but not their probabilities.” “We should now understand that many phenomena that were often defined as involving risk – notably those in the financial sphere before 2008 – actually involve uncertainty.” “Ignorance arises in a situation where some potential states of the world cannot be identified. Ignorance is an important phenomenon, I would argue, ranking alongside uncertainty and above risk. Ignorance achieves its importance, not only by being widespread, but also by involving outcomes of great consequence.” “There is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance.”

I find Zeckhauser’s chart below to be useful in creating the right mental model for his ideas. Each set of circumstances can be analyzed by assigning it a location on this matrix:

Most aspects and decisions in your life are uncertain rather than risky. It is rare that what you do is similar to the action on a roulette wheel, which is risk. In addition, the events that often have the biggest impact on what you do are often part of the domain of ignorance. Once you internalize Zeckhauser’s mental model you should naturally start to value a margin of safety more highly. You may not always be able to predict, but you can prepare.

• “Unknown and unknowable [UU] refers “to situations where both the identity of possible future states of the world as well as their probabilities.” “The first positive conclusion is that unknowable situations have been and will be associated with remarkably powerful investment returns. The second positive conclusion is that there are systematic ways to think about unknowable situations. If these ways are followed, they can provide a path to extraordinary expected investment returns. To be sure, some substantial losses are inevitable, and some will be blameworthy after the fact. But the net expected results, even after allowing for risk aversion, will be strongly positive.” “Many UU situations deserve a third U, for unique. …An absence of competition from sophisticated and well-monied others spells the opportunity to buy underpriced securities. Most great investors, from David Ricardo to Warren Buffett, have made most of their fortunes by betting on UUU situations.” “Unknowable situations are widespread and inevitable. Consider the consequences for financial markets of global warming, future terrorist activities, or the most promising future technologies.” “Many unknowables are idiosyncratic or personal, affecting only individuals or handfuls of people, such as: If I build a 300-home community ten miles to the west of the city, will they come? Will the Vietnamese government let me sell my insurance product on a widespread basis? Will my friend’s new software program capture the public fancy, or if not might it succeed in a completely different application? Such idiosyncratic UU situations…present the greatest potential for significant excess investment returns.”

Financial returns higher than a market benchmark are most likely to be found in UUU situations. These returns are caused by the fact that investments in UUU environments are much more likely to be mis-priced. The domain with the most UUU based opportunity is the world of business. The markets in which a business operates are often not liquid and information hard to obtain. The more you know about a given business the better you will be as both an operator and a financial investor in that business. Howard Marks describes the opportunity in this way: “The investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the great the likelihood you can learn things others don’t.” Focusing on the simplest possible system (an individual business in a local market) is often the greatest opportunity for an investor since it is understandable in a way which may reveal a mis-priced bet. Market efficiency is lower and potential returns are often higher if you are willing to do the necessary work to retire uncertainty and ignorance.

• “Portfolio theory built on assumed normal distributions is a beautiful edifice, but in the real financial world, tails are much fatter than normality would predict. And when future prices depend on the choices of millions of human beings and on the way those humans respond to current prices and recent price movements, we are no longer in the land of martingales protected from contagions of irrationality. Herd behavior, with occasional stampedes, outperforms Brownian motion in explaining important price movements.”

Part of what Zeckhauser is talking about is the impact of positive and negative Black Swans and why they come into existence. People like Benoit Mandelbrot were pioneers in understanding and increasing awareness of this phenomenon. The Brownian motion concept borrowed by economics from physics increasingly does not map to the real world. My daily work in a technology business indicates that “this time is different” in one very important way: “highly non-normal processes” have become fundamentally more common due to digitization and the proliferation of interconnected networks and services directed by algorithms running over those networks. The basis for my conclusion is anecdotal, but some circumstantial evidence is very strong, like finding a trout in you pitcher of milk. My thesis is that changes in the structure of the world created by technology and networks mean that assuming that outcomes will be normally distributed is increasingly problematic (at least) and potentially dangerous (at worst). In short, there are more Black Swans than ever and fewer bell-curves. More and more important investing and other outcomes are moving into UUU domains.

 

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• Financial markets are like living, breathing beings that transform themselves constantly. They move very fast and I suspect that innovation and speed will continue to be the norm.”

Financial markets are complex adaptive systems. The speed at which they adapt makes investing challenging, but also creates significant opportunities. If investing was easy, everyone would be rich. Michael Mauboussin describes the challenge here:

“Increasingly, professionals are forced to confront decisions related to complex systems, which are by their very nature nonlinear…Complex adaptive systems effectively obscure cause and effect. You can’t make predictions in any but the broadest and vaguest terms. … complexity doesn’t lend itself to tidy mathematics in the way that some traditional, linear financial models do.”

Increasing innovation and speed in markets must be matched by increasing innovation and speed by individuals and businesses in responding to that change. As just one example: “The typical half-life of a publicly traded company is about a decade, regardless of business sector. Mortality rates are independent of a company’s age.” One author of that study added: “It doesn’t matter if you’re selling bananas, airplanes, or whatever.” If a person or organization has processes that prevent a rapid and accurate response to innovation and change, they are inevitably going to feel pain. Charlie Munger’s advice here has never been more important than it is now: “We all are learning, modifying, or destroying ideas all the time. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”

1. “If super-talented people will be your competitors in an investment arena, perhaps it is best not to invest.”

Warren Buffett believes: “The secret of life is weak competition.” In other words, life is best approached with opportunity cost in mind. Why would you decide to invest in an area where you don’t have a significant advantage, particularly when there are areas where you may have a significant advantage? Charlie Munger puts it this way: “You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.” “The amazing thing is we did so well while being so stupid. That’s why you’re all here: you think that there’s hope for you. Go where there’s dumb competition.”

• “The essence of effective investment is to select assets that will fare well when future states of the world become known.” “Most investors – whose training, if any, fits a world where states and probabilities are assumed known – have little idea of how to deal with the unknowable. When they recognize its presence, they tend to steer clear, often to protect themselves from sniping by others. But for all but the simplest investments, entanglement is inevitable – and when investors do get entangled they tend to make significant errors.”

Having a variant perception that is only viewed as “right” according to the consensus later enough in time that significant value can be captured is a very good thing. Stated differently, Kevin Kwok, believes that the job of an entrepreneur is to bringing a contrarian view “to everyone else and making it non-contrarian.” Creating this outcome requires work and hustle. If you don’t want to do the work or hustle as a entrepreneur or an investor, you should buy a low cost diversified portfolio of index funds and work for an entrepreneur.

• “Virtually all of us fall into important decision traps when dealing with the unknowable.” [For example] “You get 50 e-mails during the day and you answer 30 of them. On the one that you answer the most, you take 3 minutes. In all the others, you take 45 seconds. You should take 25 minutes to answer the one that is important, but you don’t. Once that is pointed out to you, you will say that is really obvious. In other words, you should decide what is really important and make your choices accordingly.” “The brain has difficulty focusing on multiple subjects or stimuli at the same time.”

Zeckhauser is describing why people are not always rational and then giving a few examples. This slide from one of his presentations elaborates:

• “Practice improves decision performance. Awareness of problems improves decision performance.”

Zeckhauser believes people can improve their decision making skills with practice. Everyone will make some mistakes, but making fewer mistakes over a lifetime is highly correlated with a happiness. Just one example of a technique that can improve performance via practice is what Charlie Munger calls “inversion” which is what is being advocated here in one of Zeckhauser’s slides:

• “The lesson for regular mortals is not to imitate Warren Buffett; that makes no more sense than trying to play tennis like Roger Federer. Each of them has an inimitable skill. If you lack Buffett capabilities, you will get chewed up as a bold stock picker….These master investors need not worry about the competition, since few others possess the complementary skills for their types of investments. Few UU investment successes come from catching a secret, such as the whispered hint of “plastics” in the movie The Graduate… Individuals with complementary skills enjoy great positive excess returns from UU investments. Make a sidecar investment alongside them when given the opportunity.”

You are not Warren Buffett and neither am I. Buffett is also not James Simons, Sam Zell, Jim Chanos or David Tepper. We all need to understand as best we can what our limitations are in every situation. Zeckhauser is saying that one opportunity for an investor who does not have skill in a particular area is to get in the side car of someone who does. Of course, some people got in a side car with Warren Buffett while others were in the Bernie Madoff sidecar.

Picking which sidecar to get into is not simple, but if you can do it effectively the odds as favorable that it will produce a very nice outcome. You will sometimes see a claim that someone can replicate Warren Buffett’s results with a statistical factor-based index fund and margin loans. What you do not see is anyone actually doing what they claim is possible. I don’t expect to see a “Replicate Buffett’s Approach with Statistical Factors and Callable Margin Loans Fund.” I say this even though I own some factor-based index funds and very much respect the approach. Statistical factor-based investing by itself is not effective in UU or UUU situations for the reason Zeckhauser describes (you do not know the probability distribution and some future states of the world). Similarly, you can’t run a business like Apple solely based on statistical factors since much of the world is UUU.

 

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• “When you impose new regulations, smart investors always figure out ways to dodge them, finding new financial instruments or locations that bypass regulatory strictures. Each financial crisis is distinctive. Tomorrow’s financial crisis is going to be quite different from what we saw yesterday. I think we’re just going to have to live with financial crises. We can make them less likely, we can make them less severe, and we can anticipate them somewhat better. But financial crises are inevitable. If we were to put this interview in a time capsule and come back a hundred years from now, we would still observe financial crises. Preventing financial crises completely by imposing punitive penalties, either financial or by prohibiting activities that entail some danger, would be akin to preventing auto accidents by saying, ‘You can drive no faster than twenty miles an hour.’ That would get rid of 96 percent of the auto fatalities to be sure, but it would have very deleterious effects. On net, it would not be worth it.” Financial crises are predominantly situations of ignorance, not uncertainty. Once we recognize that we’re in a state of ignorance, we should change the way we think about the world. We can’t prevent the most likely next financial crisis by telling banks they need to keep an extra billion dollars or so in reserves. Instead, we should always be scanning the horizon for new risks. Once we recognize this, we could go to a situation where the expected magnitude of what we lose drops from 100 to 50, and the likelihood of a crisis goes from 1% to 0.5%. But crises will still occur, and when one does, we’re still going to lose 50. If we could cut the likelihood and severity of auto accidents in half, we could cut auto fatalities by perhaps 75%. Not perfect, but very welcome. Preventing financial crises is not possible. Cutting their likelihood and severity would greatly benefit the world.”

I don’t believe that financial regulation or fiscal and monetary policy can prevent recessions or corrections from happening. They may become a bit less frequent and better managed, but they are not going away as long as humans are human. As a result, I am always prepared for a significant market correction or recession. The older you are, the more the previous sentence should be true for you. This preparation does not mean I do not have a pool of risk assets, but I keep those funds very separate from money I will inevitably need. I have created in my portfolio what is known as a barbell portfolio with risky and non-risky assets on each side. I have avoided and will continue to avoid the situation that is depicted on the graphic which is on Nassim Taleb’s book Skin in the Game:

• “Warren Buffett, a master at investing in the unknowable, and therefore a featured player in this essay, is fond of saying that playing contract bridge is the best training for business. Bridge requires a continual effort to assess probabilities in at best marginally knowable situations, and players need to make hundreds of decisions in a single session, often balancing expected gains and losses. But players must also continually make peace with good decisions that lead to bad outcomes, both one’s own decisions and those of a partner. Just this peacemaking skill is required if one is to invest wisely in an unknowable world.” “The ideal profession for playing bridge is unemployed. It’s a terrific hobby, but if the doctor told me I could never play bridge again, I would probably say, ‘oh darn.’” “A successful marriage is like a successful bridge partnership. There will be disasters in every relationship, but you have to be able to cope with the disasters effectively and try not to make the other person feel that they’re to blame.”

I have nothing to add on the topic of playing contract bridge.

Risk, Uncertainty and Ignorance in Investing and Business – Lessons from Richard Zeckhauser