Chapter 35
Uncertainty—The Opportunity
A good joke and a good horror movie both depend heavily on the unexpected. Markets are not as entertained by the unexpected and can react violently when the unexpected resets the level of uncertainty. Volatility occurs when asset values move up or down. Increased uncertainty tends to only impact asset values in one direction and that is down. Uncertainty reduces asset values and can immobilize the decision process. Eventually, however, new levels of uncertainty are like a bad smell in a room. It takes time, but people adjust to it, and it becomes the norm. If there is not a certain level of uncertainty associated with an investment there would not be opportunity.
With the global economy going through a rapid innovation driven transformation coupled with demographic changes, uncertainty is declining in some areas and increasing in others. The efficiencies and flexibility being driven by technology are lowering uncertainty in broad macroeconomic trends. Counterbalancing this is greater uncertainty over how politics and policy will be changed by cultural transformations. In addition, uncertainty is increasing at the more medi- and micro-economic levels as regions, industries, businesses, and jobs experience more disruption with uncertain outcomes.
There is a classic book in financial economics entitled, Risk, Uncertainty and Profit, published in 1921 by Frank Knight, who was a pioneering University of Chicago professor. In the book he defined different types of uncertainty.100 In the first type of uncertainty you can predict the risk, quantify it, and maybe even mitigate it. For example, if you are playing backgammon and you need a specific roll of the dice to win, there is uncertainty what you will roll, but the possibilities can be calculated. You know what the outcomes are. Sometimes in finance uncertain risks can be partially mitigated with different strategies such as short-selling, the use of options or careful diversification. When you do not know what the potential outcomes are or the outcomes can not be calculated, that is true uncertainty (sometimes referred to as Knightian uncertainty). For example, all the possible ramifications from a war can not be calculated.
When people have been living within a certain range of risk, and have made assumptions about this risk, economies and markets can function well. It does not mean that volatility will not exist; it means there is a framework of risk within which investors will be relatively comfortable even if the movements within that framework have a high level of volatility. If these parameters are shattered and true uncertainty replaces the previous assumptions of the ranges of risk, it can lead to panic. You might think of risk as bound within a set of lines. As uncertainty increases or decreases, those lines are moved. If they are moved so far apart that investors cannot even see them, they lose their way. As an example, prior to the financial crisis in 2008, many financial firms used derivatives to limit their risks. They knew these instruments did not eliminate risk but it gave them a range of potential losses. When major financial firms, like Lehman Brothers and Bear Stearns, failed, they did not know if those derivatives, many of which were obligations of the failed firms, would be honored and suddenly these financial firms had a different level of risk on their balance sheets, and the lines of uncertainty blew out so wide they could not be seen.
Investors do not like uncertainty. However, to make money you must invest with a certain level of uncertainty, which is where the return comes from. As an investor you must go to uncertainty, determine if that uncertainty impacts your thesis, or just increases the range in which your investment will be valued. You may also have a view if uncertainty is going to increase or decrease. This could be a view about the outcome of a close election or a lawsuit that impacts a company or it could be a view on the expected consistency of economic results over the next year. When uncertainty increases, the value of risk aversion goes up. For example, the demand for safe haven investments like U.S government treasury bonds and the Japanese yen have historically risen when uncertainty increases. When the markets move toward safer havens, prices of these assets rise and it is often a signal of risk aversion.
Various investment vehicles react differently to uncertainty. Owning the shares of a company typically has little intrinsic value (assuming you do not have controlling shares) unless someone else wants to buy them from you. Therefore, they tend to have more uncertainty than many other assets. Commodities have some intrinsic value, but they are still dependent on who ultimately wants or needs the commodity. Bond valuations can be impacted by almost every feature of the economy but offer less uncertainty because of their structure—if the borrower fulfills its obligations that are part of the bond’s contract, you know what you will get paid in interest and principal and when. This removes a large uncertainty from the investment.
There are events that commonly increase uncertainty; ironically the uncertainty is often scheduled. Elections and central bank meetings often increase uncertainty. The uncertainty around elections has increased recently as political factions have become more extreme from each other. Assume one candidate is like an angry mongrel dog, denigrating his opponents and advocating for government takeover of some private companies and that any private companies pay for increased regulation. Then assume the other candidate is like a feral cat screaming to rally its supporters and guaranteeing to shut down all regulatory agencies and have corporations not pay taxes. It is not hard to see how such an election will increase uncertainty no matter who wins.
When the uncertainty rises or declines you need to question the cause and the impact of the change in uncertainty and try to determine how much it might affect your investments directly or indirectly, such as through changes in the opportunity cost of choosing other investments. Innovation increases uncertainty, especially for those that are not the innovators. At the corporate and industry level there are many items that can increase or decrease uncertainty; management with a successful track record, an understandable business plan, assets that are easily valued and healthy levels of cash flow all impact uncertainty. Companies with less tangible assets may have higher levels of uncertainty, but perhaps this can be mitigated by other factors like the ability to attract a significant amount of customers or capital.
Mitigation of uncertainty is difficult. One way of reducing uncertainty within a portfolio is through diversity. Uncertainty is unlikely to strike all regions, businesses and assets at the same time or in the same ways. While diversity does not eliminate uncertainty, it can mitigate some of its impact. Communications can reduce uncertainty. When government officials or corporate leaders lay out plans and explain their actions and rationale, uncertainty can decrease. Some research has shown that the stock valuations of companies that communicate more actually perform better,101 or of course it could be that because they are doing well they are willing to communicate more. There is a flip side for an organization that communicates heavily. If it publicly lays out its plans, goals, and targets, it opens public scrutiny of all its actions. It may limit the organization’s flexibility as it partially boxed itself into its guidance and increased the cost of adapting to change.
It is understandable that people want to develop ways to quantify true uncertainty, but it is not easily done. You can try to calculate some possible outcomes and apply probabilities, but the danger comes if you start to assume those are the only possible outcomes and that your analysis is more complete and quantifiable than it is. As you move farther away from calculating the numbers yourself and computer simulations do more of the work, it is even easier to assume a higher level of confidence in the results than may exist. For example, it is certain that a computer could calculate a series of potential actions that a person would take in each situation, but people are unique, and it may not be able to factor crazy into its model.
Doing nothing because you have not decided is bad, but making an active decision to do nothing is fine. Uncertainty can often trigger a freeze reaction, and this is not good. Decisions must be made even in the face of uncertainty. Sometimes this immobility in the face of uncertainty is insidious. Assume that within a company a team meets to address a high-risk problem, but there is significant uncertainty. The group decision is to get more information to address the level of uncertainty. This can be valuable. However, they must make sure this is not just a subconscious postponement of deciding. Someone in the room has to question if the additional work is really going to lower your uncertainty and help reach a meaningfully better answer or if you are doing additional work to postpone a decision and using unsolvable uncertainty as an excuse. If it is just an “uncertainty stall,” you are not achieving a better answer, and you are wasting one of the most precious assets of the firm, and that is people’s time, an asset lost forever.
An economy that is defined by innovation will logically increase the levels of uncertainty in certain arenas. While it allows for more rapid macroeconomic solutions, there is more disruption to people’s lives, and this can increase political uncertainty. Disruption at the business level has materially increased uncertainty. The best models can not factor in what they do not know. The expanding economy should lead to more choice, more growth, and more things available for more people, but it comes with some creative destruction that Joseph Schumpeter wrote about so famously.102 This creates greater risks but a greater number of opportunities for investments and adds to the excitement of uncertainty.