The Difference Between Risk and Uncertainty

This piece by Ben Hunt, The Three-Body Problem, is very good. It starts with fascinating insights into how bees prepare for and survive winters in the northeastern US where Ben lives.

My notes from Ben’s piece are below:

One must understand the difference between risk and uncertainty

Risk is when you have a decent sense of the odds and payoffs. You can apply statistical methods to these decisions, especially when you will be able to make this decision many times.

Uncertainty is when you do not have a good sense of the odds and payoffs. In this case, relying too much on statistical models could kill you, especially if you don’t know how many chances you have or the number of chances is limited. In this situation, game theory needs to be incorporated.

The Three-Body Problem

This is when it is impossible to predict where three variables will be in the future using algorithms that look at the variables’ history. Instead, your only chance of approximating where they will be in the future is by solely looking ahead.

Today, a characteristic (e.g. high-quality company) leading to better performance in that company’s stock is overwhelmed by the actions of a third variable: the monetary policy of central banks.

One’s best strategy in this scenario is to diversify across geographies and asset classes, and, instead of attempting to maximize return, seek to minimize maximum regret (‘minimax’). Each person’s minimax regret is subjective. For some, it might be financial ruin. For others, it may be earning a lower return than their peers.

                It’s important to not rely on computer algorithms to make our decisions during this stage. We’re hardwired pattern-seeking machines, but we must think beyond that. Be humble in knowing we will never understand how a chaotic system like this works, but we can approximately try.

It’s tough to resist The Answer because we want there to be an all-knowing, all-useful solution. Closed-form solutions like this don’t exist though.