What is... | November 18, 2014

What is uncertainty in financial markets?

Former US defence secretary Donald Rumsfeld once uttered a famous phrase about "knowns", "known unknowns" and "unknown unknowns".


In a 2002 press briefing he stated: “We know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don't know we don't know”. Some people laughed at this phrasing, but when considered closely his remarks make perfect sense. Rumsfeld was defining the relationship between certainty and uncertainty.

Being aware of the difference has the potential to be helpful in many aspects of life, including reducing overconfidence for investors and helping protect wealth over long periods of time.

Neither heads nor tails
In 1921, world leading economist Frank Knight wrote his seminal work Risk, uncertainty and profit, in which he defined uncertainty in financial markets. Knight wrote that uncertainty is when the outcome of a situation is completely unknown. Knight tells how a point of confusion around uncertainty is when people think it is measurable in the same way as risk. In fact uncertainty is far harder to define. Knight defines risk by using an example of tossing a coin, with only two outcomes and a known probability of either happening.

Discovering the Black Swan
An example of uncertainty coming to pass was, arguably, the global financial crisis that started in 2007. It fits the three-part definition of an uncertain event as detailed in Nassim Nicholas Taleb’s influential book on uncertainty The Black Swan. It was an “outlier” (outside the realm of regular expectations), carried an extreme impact and in the aftermath people constructed explanations in hindsight that tried to make it more explainable and predictable.

The problem, Taleb explains, is that we place too much weight on the odds that recent past events will repeat themselves. The Black Swan, the title of which was derived from a bird that was once thought not to exist, became a bestseller and was printed in more than 20 languages during that financial crisis. An excerpt from the book is published in the New York Times.

Different effects of uncertainty
Economist Nick Bloom explains in his paper that uncertainty can hit different groups in different ways. An oil-price spike, for example, may be good for oil producers, but bad for airlines, and either good or bad for traders and investors, depending on where they have speculated the oil price to go. Bloom points out that in 1973, the OPEC oil embargo tipped the US into recession by tripling oil prices and increasing uncertainty over future oil prices.

Insurance and uncertainty
Insurance is an example of making a decision in the presence of uncertainty – as well as a way of trying to protect against it. Buying insurance, whether it be life, home, travel or something else, requires a decision to be made about the level of cover despite not knowing how life will turn out. This environment of uncertainty could make it easy to underestimate the level of cover required – we don’t naturally walk around expecting a natural disaster like a flood or a hurricane to occur.

Some good news
Although many of the examples around uncertainty are negative – such as recessions and oil prices shocks – there can actually be a positive implication too. Uncertainty can reduce overconfidence and make you act with more caution. Overconfidence is the tendency to overestimate abilities in certain areas of life, and can also be a thinking trap. Investors can have the tendency to overestimate the return on investments and at the same time underestimate the uncertainty associated with those returns – it makes financial sense to be aware of this trap.

Overconfidence is further explored in our article What is… overconfidence: a high level of confidence in abilities, future earnings or investing is not always an accurate indicator of how things might turn out.

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eZonomics team
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