Risk—the possibility that things don’t turn out as expected—is inherent in investing. While some people ignore risk and hope for the best, other investors try to understand or manage it: They ask why the market might go against them and how they can limit any damage or loss.
One approach is to classify perceived risk into various categories: inflation risk, currency risk, interest-rate risk, liquidity risk, credit risk, even the risks of hurricanes or floods. In each risk category, estimates of the likelihood of occurrence, the cost of the likely damage or loss, and the cost of hedging or mitigation are made. Then the investor can decide whether to proceed with the investment and if risk management efforts are desirable. At times, an investment may be abandoned because the potential losses are deemed to be too large or cannot be limited. In other cases, the investment will be made even though expected returns are lower due to either hedging costs or possible losses. In other situations, the risks may appear to be modest and the investment is made without any risk mitigation efforts. All of this analysis and decision-making is premised on correctly identifying and categorizing the risks.
Donald Rumsfeld, a former U.S. defense secretary, once commented, “There are known knowns; there are things we know … there are known unknowns; that is to say, we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know.” Risk management through categorization, analysis and decision-making, as described above, is limited to “known knowns” and “known unknowns.” For example, we know rising interest rates might be a problem, but how much they might rise is unknown. And no list of risks is ever exhaustive.
There are, and always will be “unknown unknowns”—like the “flash crash” on May 6, 2010. No one expected or imagined that the market could plunge fast enough for the S&P 500 to lose 10 percent in a few seconds while VIX doubled in a speck of time. Another flash crash would be a known unknown, since we’ve experienced the first one. However, there are still many more unknown unknowns waiting in the wings; what they are or how many they might be … well, we don’t know.
Rumsfeld’s remark missed a more important datum: things we absolutely positively know are true; except that they’re not. Ten years ago just about everyone believed that home prices would never fall and that your house was your safest investment. You may recall how that turned out. Until 2008, investors knew the Fed funds rate could never go to zero, that money couldn’t be free. Yet for the last couple of years, the Fed funds rate has been zero, and short-term borrowed money is virtually free.
Dividing risk into neat categories or boxes with probabilities and loss estimates provides insight about the perceived risks, the known unknowns. However, that analysis tells us nothing about what we don’t know, and it’s what we don’t know that matters most if we want to understand what could go wrong.