Managing risk in an uncertain world

Fellow portfolio manager, John Hussman of Hussman funds is one of my favourite market commentators. His weekly market comment is especially on point this week: “Comfortable with uncertainty.”
Although Hussman's methodology is different than my firms, our stated investment objectives are the same: to outperform market returns over the complete market cycle, with less down market losses than a passive strategy. (As modest as this goal may sound, these are fighting words for the long-always crowd.)
Frequently as market analysts we are asked to forecast what market prices will do next. At my firm, we continually try to point out that forecasting is narrative fallacy of the first order. We can't possibly predict what markets will do. In fact as I frequently tell people, any time you hear a pundit seriously proclaiming what comes next—Run away!
Prudent risk management is all about assessing probabilities and implementing rules that will respond in a disciplined way to whatever market conditions present. Hussman and (F. Scott Fitzgerald) explain it this way:
“In his book On Being Certain, neurologist Robert A. Burton quotes F. Scott Fitzgerald – “The test of a first rate intelligence is the ability to hold two opposed ideas in the mind at the same time and still retain the ability to function.” Buddhist teacher Pema Chodron calls it “being comfortable with uncertainty” – being willing to take every aspect of reality as the starting point, without wasting energy wishing things were different, without denying reality as it is (even if your next step is to work toward changing things), and without needing to know what will happen in the future. “The truth you believe and cling to makes you unavailable to hear anything new. The best thing we can do for ourselves is to be open to an unknown future.”
Burton offers the same advice. Tolerating the unpleasantness of uncertainty, he writes, “is the only practical alternative to cognitive dissonance, where one set of values overrides otherwise convincing contrary evidence. Each position has its own risks and rewards; both need to be considered and balanced within the overarching mandate: Above all, do no harm. Science has given us the language and tools of probabilities. We have methods for analyzing and ranking opinion according to their likelihood of correctness. That is enough. We do not need and cannot afford the catastrophes born out of a belief in certainty.”

Excellent stuff. In an investment world full of confident prognosticators and the wilfully blind it’s such a relief to hear others admit the fallacy of this bologna.

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