STREET DOGS

For the most part investors ignore uncertainty. In general people operate on the basis that there’s a measurable risk in investment but if you’re reasonably careful in how you invest you can mitigate it.

But uncertainty is not risk. The principal assumption in most risk management models is that tomorrow will look pretty much the same as yesterday and what worked yesterday will also work tomorrow.

When that’s no longer the case, when the historical signposts are suddenly spirited away and uncertainty rears its ugly head, we find ourselves lost. When we find ourselves investing, to use the jargon, under conditions of uncertainty our innate reaction goes a long way towards explaining stock market plunges: We run away as quickly as we can.

Cue stock market wobble and then collapse.

Our aversion to uncertainty can drive us into all sorts of outwardly irrational behaviour when the hidden ambiguity inherent in many decision-making processes is suddenly made clear. When the randomness that is uncertainty strikes, our instincts serve us badly. All too often, our initial response is to assume that it’s a mistake or that it’s something temporary and to continue to believe that our models will still apply. To underreact. Then, later, to over-react.

The stock market collapses of the ‘70s, as the world reeled under multiple crises, led to the first attempts to build risk management models. The irony is that these models have themselves created an unrealistic sense of sureness mainly because they can’t capture the nature of uncertainty.

Certainty is an illusion. The best we can do as investors is to learn that uncertainty and ambiguity dog our every step. It is when we are at our most certain that we are at most risk. An assertion that’s hard to find in a risk management model.