Investing in the Unknown and Unknowable

I read “Investing in the Unknown and Unknowable” during the first week of November. Honestly, I have been consciously avoiding writing an article about it. Only rarely, and perhaps not even then, does the mind want to engage in critical thinking over complex topics.

Richard Zeckhauser’s essay is, by far, the most profound single piece I have ever read in this field. I somewhat don’t blame myself for not being willing to try digest it. Nevertheless, I’m forcing the writing as I believe you will find infinite value here, if I execute.

Zeckhauser was born in 1940. His work revolves around behavioral economics, decision making, risk management and strategy. Two interesting sidenotes:

• Richard started playing Bridge when he was a kid and went to eventually compete and win tournaments. Richard is a globally recognized player nowadays. This allows me to bring to topic a fascinating quote from Mauboussin:

“Individuals who achieve the most satisfactory long-term results across various probabilistic fields have more in common with one another than they do with participants in their own field”

• In the 1960s, the United States Department of Defense wanted to turn around the management of the entity. A modern method was thought to be required against the nuclear age. To such end, the “Whiz Kids” were recruited. This was a group of experts in economic analysis, game theory, computing, and strategy. Among them, Richard was included.

Currently, Zeckhauser is a Professor of Political Economy at Harvard Kennedy School, a profession he has exercised for something like 50 years now. Richard has been invited to speak at numerous conferences over the decades and has written several hundred articles, and a couple of books. I have only read the essay I’m discussing here, but, based on this piece, Richard’s work is of an unfathomable intellectual depth.

Investing in the Unknown and Unknowable

This essay introduces the concept of ignorance to the realm of investing. Richard defines it as those future scenarios where not even its states are known. In general, when getting from t0 to t1, we tend to think that we can imagine how t1 can look like. Given the natural uncertainty that’s embedded in our world, different potential states of nature are assigned to t1, with the sum of their probabilities reaching 100%. Ignorance, however, implies that not even the possible states of nature can be foreseen. Zeckhauser labels these situations as Unknown and Unknowable (UU), where traditional financial theory does not apply.

“This essay takes no derivatives, and runs no regressions”

UU events occur with a certain degree of frequency in real world investing. It came rather curious to me the fact that they are not discussed in financial literature. Richard posits a framework, around which there’s great depth of analysis, for investors to profit from investing in the unknown and unknowable

“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.”

Navigating these waters is no joke. It requires specific knowledge and skills. “Most big investment payouts come when money is combined with complementary skills”. However, not everyone is highly skilled in specific verticals, such as real estate or technology. Under these eventualities, Zeckhauser offers us the solution: “Sidecar Investing”.

Risk, Uncertainty and Ignorance

Effective investing is achieved when one operates in accordance with future states of nature and their respective probabilities. The first concept that emerged to help investors deal with this phenomenon was risk. Risk recognizes the existence of multiple potential future scenarios playing out, as does with their chances of occurring. Both are known. Handling risk most effectively requires solving an optimization problem.

“The essence of effective investment is to select assets that will fare well when future states of the world become known.”

Past risk, modern portfolio theory identified the existence of uncertainty (U) and, when it did, its inferences fell apart. Uncertainty is said to be present when the future states of nature can be conjectured, but we ignore the probabilities of them occurring. This territory acts as fertile soil for people who can best assess probabilities, whereupon the understanding of Bayesian decision theory is fundamental. A combination of the latter and portfolio optimization are the required skills for achieving profitable investing.

Richard acknowledged that there’s yet another dimension that escapes uncertainty. One in which there’s no possibility of recognizing the nature of future states of the world and, naturally, neither their probabilities. He defines this as the world of ignorance, wherein modern decision theory falls apart. Futile become its application. Events occurring in the region of ignorance are unknown and unknowable (UU).

Zeckhauser encourages investors to become consciously aware of the existence of UU events and learn how to act accordingly. “Unknowable situations are widespread and inevitable”. This being the case entails the opportunity for developing an analytical mental model that can extract juice from them. Moreover, it’d become a stainless toolkit, creating room for producing excess returns on a sustainable basis.

In fact, extraordinary investment returns are expected if one masters systematic approaches to UU events. Although idiosyncratic, I suspect there is an element of analogical thinking we might benefit from. A valid idea is to convert the mind into a pattern-recognition machine. If tools for dealing with UU events are built and perfected, it’s plausible to think of systematic exploitation.

The pricing mechanism philosophically forces investors to compete with one another. A common best-practice and advice that successful professionals give is to look for an arena where there is no competition. Likewise, it is not in one’s best interest to transact with wise people. If one were to do so, “experience leaves with money and money leaves with experience”.

The existence of UU events opens up a new arena for investors. One which competitors are not familiar with, and are not trained to fight in. Standard financial literature and theories equip people with spoons for a nuclear war. Inevitably, most fall prey to our unpreparedness for transiting this path. The burden of ignorance of the ones provides the edge for the others.

The Nature of Unknowable Events

By definition, most unknowable events manifest themselves in an unexpected and rapid fashion, leaving no room for anticipation and, in consequence, for preparation. They come and go in a thunderclap, such as terrorist attacks. In contrast, other UU events are prolonged in time, like the fall of the Soviet Union. An interesting phenomenon Zeckhauser observed is the role that hindsight bias plays in this. After occurring, our mind tricks us to believe the UU event was expected and that the outcome was logical. In foresight, however, we ignore their possibility of materialization.

In the real world, UU events are mostly categorized as undesirable. Buffett once stated that “it is essential to remember that virtually all surprises are unpleasant”. Even if this matter is more of perception than reality, human brains’ proclivity to be more triggered by negative events turns them into targets for media companies. News sites seem like a waterfall of this sort of information, flooding the mind with it. Thereafter, the recency and availability biases combine to make the brain overestimate the relevance, in statistical terms, of these events.

Zeckhauser speculates that the financial world appears to be one in which a good ratio of favorable/unfavorable UU events is present. It is of course not noticeable due to their inherent un-appeal to the general public, leading to them not being widely covered. Media companies focus on the rare event of lottery winning that catches people’s attention. But there are millions of millionaires in the United States, most of whom caught some positive UU event. Real estate is an industry that has incessantly created millionaires. These individuals are usually perceived as lucky and often go unchronicled.

Some UU events can also count with the element of uniqueness (UUU). Because people tend to avoid betting when they are unfamiliar with the situation at hand, Richard posits that “UUU investments drive off speculators, which creates the potential for an attractive low price”. Noticeably, UUU returns are extreme, generally resulting in a fat tails distribution.

Complementary Skills and UU Investments

Richard posits that a large percentage of UU events, and an even larger one of UUUs, reward those who undertake the situation with complementary skills. More often than not, specific knowledge needs to be cultivated for correctly identifying these opportunities. And deeper expertise is required to profit from them.

“For example, many of America’s great fortunes in recent years have come from real estate. These returns came to people who knew where to build, and what and how.

But how about becoming a star of ordinary stock investment? For such efforts an ideal complementary skill is unusual judgment.”

Only a few percent of the population possess these traits. Warren Buffett’s success is largely due to his unusual judgment, coupled with complementary skills. Serving on companies’ boards was a very common practice for him and, given Warren’s extensive knowledge of the business field and unique taste for capital allocation, his returns have been extraordinary. However, the lesson here is not to imitate Buffett, as it is highly unlikely that one possesses his skill. “That makes no more sense than trying to play tennis like Roger Federer”. It is in fact so inimitable that these remarkable individuals tend be very generous and explain what they do as best as they can:

“Buffett in his annual reports, Miller at Harvard, and any number of venture capitalists who come to lecture to MBAs. These master investors need not worry about the competition, since few others possess the complementary skills for their types of investments”

Sidecar Investments

In the early 2000s, Richard was reached out by someone whom he had worked with in the past. The person offered him the possibility to invest in Tengion, a biotech company. A sophisticated VC with relevant experience in the sector was also involved. Zeckhauser decided to proceed with the investment as he was participating in an endeavor alongside highly skilled people. And, importantly, the market was excluded from this operation.

“Such undertakings are “sidecar investments”; the investor rides along in a sidecar pulled by a powerful motorcycle.”

What is generally missed is that many of us have these types of possibilities available. And the better the position of the investor with respect to the driver, the more attractive an investment becomes. Having confidence in their skill and integrity provides the necessary elements for making an outsized bet. As many great investors point out, weighing appropriately is a requirement for excess returns.

“it would be surprising not to see significant expected excess returns to investments that have three characteristics addressed in this essay: (1) UU underlying features, (2) complementary capabilities are required to undertake them, so the investments are not available to the general market, and (3) it is unlikely that a party on the other side of the transaction is better informed. That is, UU may well work for you, if you can identify general characteristics of when such investments are desirable, and when not.”

Personal Commentary

This was the last article I needed for the first compilation of reads to be complete. I covered only a fourth of Zeckhauser’s essay, the part I believe composes the core of his writing. In a future issue, I will superficially go over the practical framework he shares and try to apply it myself with an available investment I’ve been offered. Hope you enjoyed it!

Open to Work

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Contact: Giulianomana@0to1stockmarket.com