The Behaviorist: Thank God For Uncertainty

March 29, 2011

If there’s one thing that’s certain, it’s uncertainty.

Whenever there’s a crisis and the stock market strings together more than two days of losses, you can count on hearing any number of “financial experts” spout that most-hackneyed of stock market clichés: The market hates uncertainty.

Kent GrealishThis concept is ridiculous on its face (unless meant to state the more than obvious fact that people prefer certainty to uncertainty, to which the appropriate response would be: “Well, duh!”). It begs the question, “When, exactly, is there ever certainty in the market?”

I am, of course, referring to true certainty, not the brand of certainty that’s better described as popular opinion, or conventional wisdom or even mass hysteria. True certainty, like the laws of physics, doesn’t allow for more than one outcome. If you drop an object, the immutable law of gravity will cause it to fall to the ground 100 percent of the time. Certainty in the stock market, on the other hand, is an illusion and a trap.

Twelve years ago, people were certain that the stock of any company even tangentially related to the Internet would grow to the sky. Five years ago, even suggesting that anyone could lose money investing in residential real estate would have made you an object of ridicule, if not scorn. Twenty-two years ago, everyone was positive that the Japanese would dominate the world economy for the foreseeable future. And, of course, once upon a time, investors thought that tulip bulbs were a sure thing. This is the kind of certainty you get in the market and, really, who needs it?

After all, uncertainty is another way to describe risk, and risk is highly correlated to the potential for reward as well as loss. Without risk, there is no reward, which is why Treasury bills—the textbook “riskless” investment—have a real (inflation-adjusted) expected return of zero.

Uncertainty in the market is a gift because without it there would be no opportunity. Without uncertainty, would there even be a market? Would it become an efficient market hypothesis nightmare—a perfectly priced market where prices never changed? How boring would that be?

To forget about market uncertainty is to become complacent about risk. That’s precisely why it’s so important to be periodically reminded by natural or financial disasters that the future is always a mystery.

If you fail to remember that the future is uncertain, you risk discovering that the alternative isn’t true certainty but rather the illusion of certainty. And, let’s be plain about it, that fantasy can end up costing you a great deal of money.

So what are we to do? A more realistic (some might say Zen-like) approach is to accept the uncertainty of the market and focus on reducing risk through asset allocation and indexing. After all, the best strategy is to invest with an appreciation for the way the market is, not the way we would like it to be.

Kent Grealish is a financial advisor with San Bruno, Calif.-based Quacera Capital Management LLC. Grealish, an accredited investment fiduciary® (AIF®) and a certified financial plannerTM (CFP®), provides services on an hourly, fee-only basis.



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