Risk Savvy

We all crave certainty. Especially when it comes to money since it can have an enormous impact and influence on our lives. Most of us are still anxious to see stock market predictions even if they have been consistently wrong year after year.

Technology in some instances can create more certainty but just because we can trade stocks daily or have an algorithm does not deliver certainty.

In an uncertain world, looking for certainty is a big mistake. What we should focus on is our decision making process and in that sense making things simple is a better approach. Simple rules can make us smart and create a safer more certain world.

No matter how much we talk about simplicity, many investors want to see a more complex situation. And this is no more greater than when you disagree with someone who takes a simple approach.

Known risk is a world where all alternatives, consequences and probabilities are known. Think betting on the number of a dice roll. Uncertainty in most places is huge compared to the world of known risk. In an uncertain world it is impossible to determine the optimal course of action by calculating the exact risks. We have to deal with the unknown unknowns where surprises happen all the time.

Using a “less is more’ approach, you see that complex problems do not always require complex solutions and it is better and more sensible to look for the simple solutions first.

There is a mathematical theory that tells us why and when simple is better. It is called the bias-variance dilemma. The key idea is that the total error when making a prediction consists of three components:

Total error = bias squared + variance + noise. I wont bore you with the details, but the essence of the theory is what Einstein said - make everything as simple as possible, but no simpler.

Simplicity depends on a couple of features.

Firstly, the more uncertain, the more we should make it simple. The more certain the more complex it should or can be. The stock market overall has high certainty whereas a single stock has high uncertainty. That’s why a $100,000 dollars in an index fund contains less risk than $100,000 in a single company investment.

Secondly, the more alternatives, the more we should simplify – again, that is why index ETFs are a gift to sensible investors who desire simplicity.

So make it simple when you have high uncertainty, a lot of any alternatives, and a small amounts of data. Make it complex when you have low uncertainty, few alternatives, and high amounts of data.

Remember to choose the alternative that avoids the worst outcome. That’s’ why we say focus on not losing money rather than trying too hard to make some.

So when it comes to investing (decision under uncertainty) here are four ways to think about it:

1. Satisficing - close enough is good enough. Use ETFs not single stocks.
2. Advice taking – trust but verify.
3. Imitate your peers - who has the most relevant experience and follow them.
4. Habit - stick with what you know in order to avoid disappointment rather than try to maximise your return.