Uncertainties

I spend quite some time today reflecting on the concept of uncertainty, after reading a quick tweet from Farnam Street.

In investing, uncertainty is distinct from risk. Investors have a difficult time dealing with uncertainties as the nature and magnitude of uncertainties cannot be defined. Ironically, many market participants fail to appreciate that profit making opportunities arise precisely because of the existence of uncertainties.

If you are not convinced, then try to invert the situation, and imagine a world devoid of uncertainties. In this fantasy world, trends in security prices are non-existent, an EMH nirvana. Scientists will know the exact position and momentum of quantum particles. Major religions such as Christianity, Judaism and Islam will not exist. Quite possibly, our brains will evolve in a completely different manner, as we no longer require short-cuts and instinctive reasoning. I can go on, but you get the picture.

Uncertainty is embedded in the nature of all things. This is the principal reason why we must always allow a margin of safety in our investments. Just as a good engineer builds redundancies into critical systems, we must allow for uncertainties inherent in businesses operating in a complex system where humans exercise free will.

By logical inference, we cannot be the master of a universe riddled with uncertainties. This is why Buffett and Munger repeatedly advocates the virtue of humility. Humility enables us to accept that there are things that we cannot know, which is the first step towards acknowledging the limits of our competence.  If we know where our boundaries lie, we can then take the next step of pushing out our boundaries through the accumulation of knowledge and wisdom.

And only thus, shall the meek inherit the Earth.