The Rational Investor #028: Michael Mauboussin on the Difference Between Risk and Uncertainty
Happy Saturday to you,
Welcome to the 28th edition of The Rational Investor Newsletter.
Today’s quote comes from the book More Than You Know: Finding Financial Wisdom in Unconventional Places by Michael Mauboussin. It’s a great book filled with lots of neat stories from a wide variety of fields that all connect back to investing and finance. Highly recommend.
The only change I made to today’s quote is to break up the paragraphs for easier readability.
Onto the main event…
Here’s Michael Mauboussin on the Difference Between Risk and Uncertainty:
So, how should we think about risk and uncertainty? A logical starting place is Frank Knight’s distinction: Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like.
So, games of chance like roulette or blackjack are risky, while the outcome of a war is uncertain. Knight said that objective probability is the basis for risk, while subjective probability underlies uncertainty.
To see another distinction between risk and uncertainty, we consult the dictionary: Risk is ‘the possibility of suffering harm or loss'.’ Uncertainty is ‘the condition of being uncertain,’ and uncertain is ‘not known or established.’
So risk always includes the notion of loss, while something can be uncertain but might not include the chance of loss.
Why should investors care about the distinctions between risk and uncertainty? The main reason is that investing is fundamentally an exercise in probability. Every day, investors must translate investment opportunities into probabilities—indeed, this is an essential skill. So, we need to think carefully about how we come up with probabilities for various situations and where the potential pitfalls lie.
If investing risk is, in fact, an exercise in probabilities, how can we better evaluate market risk?
The best probabilistic way I know to evaluate market risk is to consider the impact of time on the probability of positive returns (and loss). Below is a graphic from First Trust that offers this probability in visual form:
As this chart hopefully makes abundantly clear, the best antidote to market risk is time.
And yet, people will still foolishly try to ‘play the market.’ It’s a lot easier to be a permanent owner.
Thanks for reading. I’ll be back again next week with more timeless wisdom from great investors.
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