Thursday, April 1, 2021

Risk and uncertainty - The problem of closing the knowability gap

"There is a big difference between risk and uncertainty. You are dealing with risk when you know all the alternatives, outcomes and their probabilities. You are dealing with uncertainty when you don’t know all the alternatives, outcomes or their probabilities." 

- Gigerenzer's Simple Rules

Gigerenzer's definition of risk and uncertainty lends itself to the idea that there is a continuum of knowability between risk and uncertainty. Our efforts to gather information will potentially reduce the level of uncertainty we will face. We can develop added alternatives, tighten our view of outcomes, and better infer probabilities. Some alternatives, outcomes, or probabilities may not unknown, but a good investor closes this gap. However, just saying that more information should be gathered does not address the question of how to make better decisions in a complex world. The limit to reducing uncertainty may have to be processing not gathering information. There may be needed heuristics or rules of thumb to help with the process. 

I am a big fan of Gigerenzer's fast and frugal decision-making for dealing with an uncertain environment. Instead of embracing the failings of rules of thumb, Gerd celebrates the skill of humans with making complex decisions under tight time constraints and limited information. He focuses on the practical realities associated with different decision environments. For example, from my view, trend-following is fast and frugal decision-making at its best - using simple tools like a trend to beat back market complexities. We have to pull out the right technique from our adaptive toolbox of heuristics. 

Once we place investment risk and uncertainty on a continuum, we change the dynamics of how we address the problem. We close the gap when we can, and develop our experiential skill at finding short-cuts to ensure that risk and uncertainty is managed with proper action. 

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