Given the turbulence seen in financial markets and elsewhere these days, people are rightly confused and worried about the future. Forward planning under current circumstances is incredibly difficult. I have spoken to good friends who are used to planning months or even years ahead in their businesses. But these days, most of them cannot plan more than a week ahead. This state of affairs is intolerable for most people, and quite understandably so. However, one CAN still make sense of such situations – provided that one understands the difference between risk and uncertainty.

Defining Terms

The simplest definition that I have ever seen of the difference between risk and uncertainty goes something like this:

In a risky situation, you know all possible events. You profit or lose depending on how accurately you anticipate the possibility of each event.

But in an uncertain situation, you have no clue what the events themselves are. In that situation, you have no idea even how to begin assigning probabilities. What is the point, after all, if you have no clue what future events will be?

Risk

A simple illustration may be in order. Consider your daily commute. If you take the same route every single day, you know the schedules very well. Therefore, you have a pretty good idea what percentage of the time your train will arrive exactly as and when you expect. You can therefore estimate, based on past experience and travel times, the probability that you will be on time to the office on any given day.

You take a risk every single day that you will be late to work. But you can manage this. That is because you can estimate from experience and available information when your train will arrive and how long it will take. You even know, based on those same factors, roughly how often you can expect to get a seat on the train.

In this situation, you can plan ahead with reasonable confidence and take clear measures to manage your “downside risk” – that is to say, the probability that you will be significantly late.

Uncertainty

But now suppose that you have no clue what the train schedule is. Your local train company doesn’t provide one. The train arrives more or less at random with no rhyme or reason. (This is an intimately familiar situation for people living in, say, India. Or the UK, for that matter.) You have no idea whether it will be empty or full. And you don’t know how long it will take, because the number of stops and the duration of each of those stops changes at random.

That is a situation full of uncertainty. You have no clue when you will arrive at the office because you have no idea what the sequence of events is to get there. Therefore you have no way of planning ahead, at all.

The best that you can do in this situation is to just show up and see what happens. You have to leave a HUGE buffer of time between your arrival at the station and your planned arrival at work. That buffer could be as long as an entire day. So what’s the point, then, even to try to take the train in the first place? And that is the reaction of most people under an uncertain regime.

Risk Can Be Managed…

It goes without saying that working with risk is profoundly different from working with uncertainty. I’ve spent the better part of a decade working closely with traders, understanding how they view risk. As a result, I have a strong appreciation of what it takes to prosper in situations of risk.

Let no one be under any illusions about what it is like to be a trader. A trader’s life is one of stomach-clenching tension and constant worry. I personally knew a trader who would worry himself sick about the impact of a small movement in 30yr swap rates on his large, inherited, portfolio of highly illiquid long-dated long-lockout short Bermudan swaptions. (This is ancient Geek for “really complex positions that could blow up an entire book but cannot be offloaded easily”.) The possibility of bad news from, say, the Asian markets, causing a loss of $10 MILLION (yes, really) in his portfolio, would keep him up at night. He would get into the office at 6am to hedge his positions – which is absurdly early even for traders.

But he always managed to keep that portfolio under control. He did it by using every possible opportunity to mark down those positions. Since they showed up as negative on his book, anytime he made decent money in trading during the day, he would make their valuations even more negative and offset the impact with his profits from the day.

Consequently, he immunised that part of his portfolio from serious downside risk. His approach was the epitome of prudent risk management. He never asked for those positions and never wanted them, but he had to deal with them. And he did so with an expert touch.

… But Uncertainty Can Kill You

This specific trader was able to manage his risk very well because he knew, or could intuit, the entire possible spectrum of downside events. He then assigned mental probabilities based on vast experience, mathematical talent, and great skill. The lesson here is clear. If you know and anticipate the events that can kill you or destroy everything you have, then you can hedge against them.

But if you have no idea what the future holds… how can you expect to hedge against it?

The current situation with the pandemic is a very good example of extreme uncertainty. Governments are literally making up policy on the fly. You can see this in press conferences where health secretaries and Prime Ministers are practically brainstorming out loud, in front of the entire press and the whole world, about national policy.

As a result, no one has the first clue what will happen tomorrow.

Will air travel be possible? From where, and under what conditions? What will be the quarantine requirements – 14 days, or 10, or 7, or 5 with two negative RT-PCR tests? Will businesses be allowed to open and function? Which types, and under what circumstances, and what kind of capacity?

No one has any good answers in these situations. Forward planning is impossible. Any attempt to allocate capital under a regime of significant uncertainty will more often than not result in significant losses.

In this situation, one has only two options. The first is to muddle through and take massive potential losses – with no means whatsoever of hedging or mitigating them. The second is to sit still and wait for things to settle down.

One doesn’t need a doctorate in Philosophy to figure out which is the more likely choice.

Profiting From the Difference Between Risk and Uncertainty

Simply put, uncertainty ties up far more capital, time, and resources than risk. That is why uncertainty kills businesses and destroys confidence. This is also why the prime objective of sound government economic policy must be to provide consistent, rules-based, transparent frameworks and laws for business activity.

The key to profiting from risk is to understand the full spectrum of events and assign probabilities to those events correctly. That assignment process happens through a combination of intuition, experience, skill, and mathematics – and most people do all of this unconsciously.

But the key to profiting from uncertainty is very different. Essentially, in times of great uncertainty, you literally just have to try something and see how it turns out. This takes much more than mere risk-taking. This requires tremendous courage.

Consider the following scenario. It is January, 49 BC, and you are standing on the banks of a river called the Rubicon, outside of Rome. Your name is Gaius Julius Caesar. You are facing severe opposition from your political enemies in the Senate. They want to try you for treason because you ran a bit hog-wild in Cisalpine Gaul and beyond, especially in Britain. Your conquests there were unlicensed and you fought wars, and committed great atrocities, without Senatorial sanction.

You know that if you submit to the Senate, you will be imprisoned and destroyed. You have an army at your back, absolutely loyal only to you, thanks to the reforms of your great predecessor Gaius Marius. But if you cross that little river in front of you, then you have absolutely no idea what could happen.

What do you do?

Conclusion – Cast the Dice

Caesar took a massive bet on uncertain outcomes, and won. He went from a de facto dictator, to a de jure one. He was the culmination of far greater forces that had been pushing the Roman Republic toward an Empire for over a century. And he was able to do so because of several factors that he actively cultivated to his own benefit.

First – he forged his own destiny. In times of uncertainty, people hunker down and become passive, waiting for the storm to pass. This is an overwhelming temptation and very few can resist it. But this merely prevents losses in the present. It is no protection at all from future events. Those who profit from the difference between risk and uncertainty, do so by seizing the day and taking opportunities as they come.

Second – he had significant allies to help him. This is critical for getting through times of great uncertainty. Confronting extreme volatility and uncertainty entirely on your own is terrifying. When you have an army behind you – literally or metaphorically – the task becomes much easier. So seek out allies and combine resources, wits, and experience. This will get you through such times.

Third – Caesar understood the need to act decisively. This is critical. Once committed, do not stop. A leader can afford to be wrong, but never indecisive. Uncertainty compounds the natural human tendency toward indecision – at precisely the time when that trait is most dangerous. Crush that trait and conquer it. If you do not, your ventures will fail.

Uncertainty is scary, no question about that. But you aren’t helpless in such situations. If you understand the difference between risk and uncertainty, and apply a few simple but profound ideas in uncertain situations, you can and will get ahead.