The cost of reducing uncertainty

‘Nothing is certain’ might be the only statement we can say with certainty. We don’t know what the next day’s going to bring. Maybe not even the next hour. We can only ‘expect’ what it would turn out like.

‘Not knowing’ or uncertainty about the future makes us uncomfortable. At times its driven by our own experiences, something we saw, we heard about or we read about, or just the feeling of that loss due to an unforeseen and unfavourable outcome.

We try and gather as much information we can and reduce this uncertainty. Or we try to protect ourselves from that unexpected loss we are worried about. What’s the first thing Jack does when he buys a new home? He buys insurance against theft or burglary, maybe even damage protection or fire insurance. Jack doesn’t care about how likely or how ‘probable’ any of these events are. He’s mostly worried about the large loss related to a small probability event. 2% chances of any of this large loss hurts him more than 98% chances of a small loss (the premium you pay). And that is the premise on which the concept of insurance and the industry itself is built on! The derivatives markets with different hedging products, futures, forwards and options are constructed (and sold) in the form of ‘protection’ .

You need to pay someone to take the other side of the trade. Small probability of large losses, which Nassim Taleb calls ‘Tail risks’ are the risks we should actually be worried about, in fact.

Our pessimism has no nadir when it comes to small probability-large LOSS events but at the same time our optimism has no zenith when there’s a small probability-large GAIN events. In 2018, people spent more than $6bn on lottery tickets in Spain. The chances of you winning the lottery prize is 1-in-a million, probably worse. The chances of us ‘netting’ in gains are really, really small. Here, we are willing to pay for ourselves to take the other side of the trade. At gaming/gambling houses, the mighty ‘house’ knows how to use this very effectively and uses the same risk-pooling strategy to turn the equation the other way around.

So the next time you want to reduce uncertainty, take a minute longer to think about what are the odds of that event happening and what is the magnitude of the impact of that event on your life.

Peter Bernstein put it perfectly in one of his books,

“We are never certain; we are always ignorant to some degree. Much of the information we have is either incorrect or incomplete”

See you next time,

The Atomic Investor

1 Comment

  1. niftyfifty1994 says:

    Wery well written so very true

    Like

Leave a Comment

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s