Decision-making is hard because there is a fundamental and unavoidable ignorance about the future. We are especially uncomfortable about outcomes produced by processes that we don’t understand well. We’re much more comfortable with risks that we can quantify, model and forecast. This is called “ambiguity aversion“. We are so uncomfortable with the former (uncertainties) that we’ll fool ourselves into believing they’re the latter (risks), with potentially catastrophic results.
When we’re talking about making decisions subject to ignorance, there are two helpful categories, first described by economist Frank Knight (1921). There is risk, where we understand the process that produces outcomes and their probabilities. Think about a game of black jack or the average mortality of a 65 year old woman (see page 26). We know the probabilities because we understand the mechanics of the card game and have loads of experience with mortality. As a result, we can set odds at a casino and price insurance policies with confidence.
Then there’s another class of ignorance, which is much more profound. Knight called it uncertainty. This characterizes our hardest decisions, such as whether to get married, have children, where to live, change a career, rent or buy a home or make an investment. The outcomes depend not just on our own actions but also the unknown actions of others. They depend on known unknowns, e.g., who will be president, and unknown, unknowns such as technological developments. Such decisions can be subject to black swans, events which are unexpected and can have a major impact.
The movie, The Big Short, which I recommend highly, describes a catastrophic example of what can happen when we pretend that a profound uncertainty is merely a risk. The movie explains (entertainingly) how the creation and valuation of Mortgage Backed Securities and Collateralized Debt Obligations required some pretty big assumptions about how home prices work: that they never fall. They are merely risky and risk can be “managed”.
Few were honest about how little we know and can predict about a system as complex, unpredictable and uncertain as the housing economy. So the industry pretended, supported by rating agencies, regulators and virtually everyone who was making money, until the music stopped.
All you need in this life is ignorance and confidence, and then Success is sure.
– Mark Twain, 1887
I experienced the tension between uncomfortable uncertainty and “tractable” risk in my career in banking. For example, there are competing theories about when one should refinance a loan. Most of them rely on costly and complex models about how interest rates change over time, treating it more like a risk than an uncertainty. However, interest rates follow an uncertain process that’s essentially unknowable. Therefore, there is no single correct answer to a refinancing question; the best one can hope for is to have a range of plausible answers (which statisticians call a confidence interval). If that interval is wide enough, it may not matter too much which model you use.
The best way to handle ambiguity is with honesty, modesty and transparency. This can be ironically liberating. Knowing that without a crystal ball, we can’t get a decision under uncertainty exactly right means that such decisions deserve limits on the time, money and anxiety we invest in them. There are diminishing returns to investing in researching, modeling and consensus-building. At the end of the day, “…you can’t tell the quality of the decision you are making by the outcome that will be produced.” (HBR 11/21/14) So, invest only as much as is reasonable in any decision, be honest about the margin of error, and move on.