Uncertainty - the gap between what we know and what we need to know

 

"...with respect to decision-making, uncertainty refers to the gap between available knowledge and the knowledge decision-makers would need in order to make the best policy choice."  -from Decision-making under Deep Uncertainty: From Theory to Practice

I like this definition. Uncertainty is a knowledge problem. Investors can work at trying to close the ignorance gap; however, the cost in time and money may mean that investors will always face a degree of uncertainty. 

There is a difference between decision-making under risk which can measured and decision-making under uncertainty. Yet, there is a continuum of uncertainty that can range from complete certainty to complete ignorance (inability to even frame the issues). Over this continuum, there exists different levels of uncertainty as described by those studying deep uncertainty:

Level 1 - represents situations where one is not absolutely certain but one does not see the need to measure the uncertainty in any explicit way. There are no guarantees that you will not be surprised by something unanticipated, but it may not be worth measuring. 

Level 2 - models or inputs can be described probabilistically and choices can be assigned probabilities. Choices are based on expected outcomes and levels of acceptable risk. This may be the traditional uncertainty most often discussed. 

Level 3 - there is a limited set of plausible futures and probabilities cannot be assigned to them. There is a focus on scenario analysis or what can happen in different worlds. This level of uncertainty often describes longer-term investing out beyond a few years.   

Level 4 - there may be many plausible futures, but they cannot be handicapped, or we are in situations where we know that we do not know what is likely, black swan problems. We can only try and protect ourselves from the unknown.

The job of a good investor is to try and manage their ignorance over different horizons. If the knowledge gap is too large, walk-away or take action that will limit downside. If the uncertainty can be controlled versus others, take more risk.