Where the markets will go? Who cares?… I know my Investments!

These days, when I meet my friends and relatives, more often than not the conversation veers towards a version of "Where do I see the markets going forward over next...?" The time frame does not matter; I have come across all, from next few days to weeks, to months, to years. Yet invariably my answer, most of the times, has veered towards "I don't know!" And this always comes as a bit of a shock, but more importantly as a disappointment.

However, it's not hard to understand their shock and disappointment. Perhaps, I would have felt the same if I were to come across someone (like a doctor) whom I see as an expert and if most of the time his responses to my queries are "I don't know!" The disappointment they feel is probably much greater because they have seen my peers launch into highly sophisticated exposition of their ideas laced with anecdotal evidences to support their views about the future. I do not plan to say that such thought process and its exposition does not merit its own separate existence. However, I do think clients fail to see it for what it is 'A probable scenario out of multitudes of likely ones'. And the fact that analysts do not communicate this clearly only complicates the matter. It's not surprising, then, that most clients blindly accept one probable scenario as the grain of truth of that time.

On one hand, this blind 'faith' on expert view has hurt many clients. On the other, failure of my ilk in clearly explaining and communicating to the clients that their views are just one of the probable scenarios from many, that investment research is not a precision science, that risk is not uncertainty we have misled them into believing the omnipotence of our views.

One of the big problems which makes rectifying the current situations very hard is that we have made very little focus in understanding the investment philosophy of an analyst or fund manager. I believe that analysts and fund managers at best have failed to communicate their philosophy clearly & at worst; I would not be surprised that many of them do not have an investment philosophy to start with. This does not absolve clients either, their insistence on focussing more on outcomes than processes, on investment strategy rather than investment philosophy.

In the series of blogs that I would be writing, I would try and change this. It would be my humble attempt to outline the investment philosophy of MoneyWorks4me. I hope this will help all of us in developing our own investment philosophy and focussing more on investment processes rather than outcomes.

However, before we start to understand MoneyWorks4me philosophy of investment, we need to understand the nature of few priori. These priori are what an investor faces irrespective of his philosophy or strategy. These priori are around which the processes must be built and rebuilt to derive a competitive edge in the market, so that over long term better processes are likely to result in better outcomes.

Let's understand the most important one of these first:

What is uncertainty and how is it different from risk?

Many investors and analysts whom I come across think that uncertainty and risk are the same; few believe that while risk can be quantified, uncertainty cannot. But these are known unknowns. I believe they are both wrong and it's very important to understand risks, uncertainty and known unknowns. Probably, I lost you over there. Let me help you a bit.

Let's assume I fall madly in love with a girl. The fact that she can accept or reject my advances is a risk that I will have to take if I really wish to spend my life with her. What her dreams are, do they have any synergy with my own dreams? How does she think? Will it complement my own or will it clash with my own thinking? All such questions are risks. How her family is, especially her parents and siblings, are known unknowns. I know that some time in my relationship it will do crop up and I will handle it as it comes. However, I can just hope that they are not deal breakers.

But none of these is uncertainty! These are just different forms of risks. Some of these risks I know and can quantify them into probabilities because I have the necessary data. But others I do know they may exist, however, I do not have sufficient data to understand the probabilities of it and hence, I cannot quantify it as of now. Uncertainty is very different from either of these. Uncertainty in its classic sense can neither be known before it's going to happen neither it can be quantified.

What profession our kids take (remember I still have to propose to her) will qualify as uncertainty. And unlike risk, uncertainty is not necessarily a bad thing when it materialises. It could be a shock to you, it could be quite far away from your wildest imaginations and but it need not be bad either. Imagine a gay actuary son! The fact that he is gay might shock his parents but the fact that he became an actuary should make them proud beyond their imaginations.

One of my idols, Dr. Richard Feynman, had put the concept of Uncertainty in a much more lucid manner than I have done. I suggest that investors should keep visiting this small video clip from his interesting interview with BBC. “I can live with doubt, uncertainty and not knowing. I think it’s much more interesting to live not knowing than to have answers which might be wrong. I have approximate answers and possible believes with degrees of certainty about different things, but I am not absolutely sure of anything and many things I do not know anything about”

http://youtu.be/3zi699WzAL0

And remember when you have seen this video; he is talking about the physical world and the universe which have much more predictable behaviour than the psychological behaviour of the human mind, especially when it is a part of a crowd.

So before we go, let's take another example from the investment world. For a moment, let us think that we decide to make a major investment in an oil company. We have very diligently analysed the culture of the company, the current reserve profile of the company's exploration block, we have been very conservative in estimating how the oil prices would go over next few years.

However, if you pay a closer look most of these factors like its production rate from its blocks, its reserve potential, oil prices are risks that can be quantified as well as it is widely understood by the investors.

If the company has exploratory blocks then these are known unknowns. We do know that a reserve discovery is possible. However, we neither know if this will be a big discovery nor do we know if it will be economical to extract it. As a result, even though an exploratory block qualifies as risks it cannot be quantified.

But how about technology? If tomorrow a technology evolves (For e.g. solar achieving grid parity or nuclear fusion energy production finally becoming possible, but more importantly, also becoming net energy positive?), will it be a known unknown or an uncertainty?

The very fact that I can mention it means that it's a known unknown. However, the probability of it becoming threat to oil is small enough for us to think it's an uncertainty.

Then what would qualify as an uncertainty? A year back I would have said oil price wars between Saudi Arabia and US leading to failure of OPEC OIL CARTEL would have qualified as one.

However, here is the kicker investors would not have expected this to happen a year before. Not even at a probability level thinking it would be possible to have gauged it, making it uncertainty.

Can you think of other places, other than investment, where you see risk as well as uncertainty together?
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This article is submitted by www.moneyworks4me.com