Consider this case: You have a new business idea. You share this with your friend. Moreover, he asks, “What is the probability that your new idea will work. Also, if it does, what is the return you will get?”
This question leaves you dumbstruck as you don’t have an answer to your friend’s question.
As a result, we spend too much time in reducing the risks and uncertainty associated with it.
However, there is a big difference between risk and uncertainty, which many people tend to ignore or fail to understand.
In this story, let’s understand the risk and uncertainty and how you can mitigate them (wherever possible) in investing.
We take risks knowingly or unknowingly in everyday life. However, what is the risk? A potential of loss or any other negative outcome. Few salient features of risk are:
- You can predict the probability of a future outcome. For e.g. rolling a dice or picking a card. Before we roll a dice or pick a card, we know in advance the odds of each possible outcome.
- Since you can predict them, they can be quantified and managed.
Uncertainty is the absence of what the outcome can be, forget even evaluating probabilities of an outcome to occur. Few salient features of uncertainty are:
- Unlike risks, where you can manage the probability of risks, it is difficult to predict the outcome here.
- Since they can’t be predicted, they can’t be measured, managed and controlled.
The stock markets are criss-cross of both risks and uncertainty.
Risk involves evaluating the probability of the success of your portfolio based on past performance, fundamentals, growth potential, cash flows, management, business model and many more. On the other hand, uncertainty revolves around global events such as trade wars, natural apocalypses and many others that are difficult to predict. Here, there is complete dark box as the outcome of an event is completely unknown. This means you can’t measure it as you don’t have any information or data on it.
A real instance of risk and uncertainty in investing:
There are two portfolios A and B each consisting of 10 investment ideas. Can you tell which one will perform better in the next 3 years?
You cannot make an accurate guess on the same, but you can analyse the performance of stocks over the last 5 years, their growth potential, management pedigree & other parameters. After doing this analysis, you can attribute the probability of the successful portfolio. For e.g. you may think portfolio A has 75% chance of better performance or portfolio B has only 25% probability of losing the match.
Now let’s again say that there are two portfolios A and B, each consisting of 10 investment ideas. Which one shall deliver better returns?
Let’s say that no investment ideas have been shortlisted for either portfolios. You are clueless as you don’t have any idea on the stocks, their fundamentals, growth or management. Hence, predicting the outcome even though the number of stocks and rule remain the same.
This is uncertainty in investing.
Why Risk (Calculated) & Uncertainty Is Good In Investing?
Now you’ve understood the difference between risk and uncertainty, let’s look at the problems.
More often, while investing, we act like everything is a risk. The truth is when we act like everything is a risk, we significantly decrease the chance of success and increase the chance of failure. When we start thinking that each factor is unknown, it translates into inaction.
Barry Ritholtz, an American author and equities analyst, CIO of Ritholtz Wealth Management, once quoted: We’ can’t use not knowing as an excuse to not act – because we never know.
Avoiding uncertainty and even overexposing ourselves to uncertainty doesn’t work as both have adverse outcomes.
We all know the famous adage, “No risk, No gain”.
So if an investor wants to create wealth (sustainable one), they have to take calculated risks (where the probability of a negative outcome is low and positive outcome high) and face uncertainty rather than running away.
Uncertainty is a part and parcel of life, even while you walk, drive, start a new job and many more. You never know what may happen next. However, you don’t run from them. Similarly, you never know what uncertainty stock markets may face. So instead of running away, an investor should avoid high risk but embrace calculated risks and uncertainty in the stock market. And, if this still looks difficult, having an expert by your side will increase your chances of success manifold in the stock market.