Enrich Your Future 31: Risk vs. Uncertainty: The Investor’s Blind Spot

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 31: The Uncertainty of Investing.

LEARNING: Equity investing is always about uncertainty.

 

“Most investors think of investing as much more like risk and forget there’s a lot of uncertainty. That’s a problem because investing is always about uncertainty. You have to recognize that we cannot rely on historical data to tell us that much about the future.”

Larry Swedroe

 

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 31: The Uncertainty of Investing.

Chapter 31: The Uncertainty of Investing

In this chapter, Larry explains the difference between risk and uncertainty. He highlights that one of the most important concepts to grasp is that investing is about dealing with both risk and uncertainty.

University of Chicago professor Frank Knight defined risk and uncertainty as follows: Risk is present when future events occur with measurable probability. Uncertainty is present when the likelihood of future events is indefinite or incalculable. Larry further explains that risk involves known probabilities, like casino odds or life insurance estimates, while uncertainty involves unknown outcomes, such as major events like the Great Depression or COVID-19.

Larry explains that we sometimes know the odds of an event occurring with certainty. For example, because of demographic data, we can reasonably estimate the odds that a 65-year-old couple will have at least one spouse live beyond 90. However, we cannot know the exact odds because future advances in medical science may extend life expectancy. Conversely, new diseases may arise that shorten life expectancy.

Why must you understand the difference between risk and uncertainty?

Larry insists that it is crucial to understand the difference between risk and uncertainty. This understanding is key, as many investors mistakenly view equities as closer to risk, where the odds can be precisely calculated. This misconception often arises when economic conditions are favorable. The ability to estimate the odds gives investors a false sense of confidence, leading them to make decisions that exceed their ability, willingness, and need to take risks.

However, Larry adds that the perception of equity investing shifts from risk to uncertainty during crises. Since investors prefer risky bets (where they can calculate the odds, like investing in a stable company with a proven track record) to uncertain bets (where the odds cannot be calculated, like investing in a startup with an unpredictable future) when the markets begin to appear to investors to become uncertain, the risk premium demanded rises, and that is what causes severe bear markets.

Further, dramatic falls in prices lead to panicked...