Into the Unknown

As Covid-19 shows no signs of disappearing, how long can individuals, businesses and countries remain in a semi operational state? While the global stock market crash caused different responses, resulting in recovery in some sectors and slumps in others, investors are forecasting and calculating at a very apprehensive time.

Covid-19 increased uncertainty in health, jobs and finances, and from New Zealand to Spain and Italy to Peru, movement was restricted and business came to a standstill.  While many claim that a pandemic was predictable, most of us are still shell-shocked.  Impossible to ignore is the capacity to acclimatise to new circumstances has become a trademark of brilliant business.

The pandemic has certainly put the term ‘risk’ back on everyone’s radar, and while we try and embrace our new normal, insecurity and anxiety about the future is palpable. Covid-19 and the economic shutdowns it prompted around the world have contributed to a massive fall-out, and investors may find themselves in the firing line. There is no financial model or risk analyst that could have predicted its occurrence this year.

The study of risk has been around for centuries, offering benefits including increased awareness, well-informed choices and enhanced responsibility. Gerolamo Cardano, a 16th-century mathematician and doctor was the father of probability theory. He decided to tackle betting games mathematically and wrote a gamblers manual outlining how to navigate the ‘sample space’ of possible events.

“No-one knows what the future holds with absolute certainty, but we must make decisions anyway.”

In the 1020’s, John Maynard Keynes and Frank Knight outlined a distinction between risk (which can be measured with probability calculations) and uncertainty (that is immeasurable). According to Knight, risk applies when we do not know the outcome of a given situation but we can accurately measure the odds. Uncertainty, on the other hand, applies to situations where we don’t have access to the information we need in order to estimate accurate odds in the first place.

Peter Bernstein, an American financial historian, economist and educator, highlights how our perception of risk, especially with respect to decisions regarding financial outcomes, advanced from ancient times to the present.  He chronicles the history and evolution of human desire to manage uncertainty. In his book ‘Against the Gods: The Remarkable Story of Risk’, Bernstein illustrates how risk impacts a wide range of ventures.

Risk management has always been central to investment decisions, but since the pandemic it has never been so pertinent, having far-reaching costs and consequences in both corporate and personal life. However, in the market, confidence in decision-making is vital irrespective of the stressors on or off the trading floor.

Understanding Risk versus Uncertainty:
Risk can be determined as ‘known knowns’, (default on payments), known unknowns (risks that investors may be aware of but unaware of the size and effect of the risk) or ‘unknown unknowns’ (these are impossible to spot). The metaphor of a black swan was thought up by derivatives trader-turned author Nassim Nicholas Taleb to describe unknown-unknown events. The events of September 11^th, the 2008 housing crash and the 2011 earthquake tsunami disaster in Japan are recent black swan events that have stricken livelihoods, businesses and economies beyond repair. Black swans are exceptions, where investors can’t benefit from any prior planning, because nothing in the past can convincingly point to their possibility. Covid-19 is classed as a known unknown.

In “Flu Hunter: Unlocking the secrets of a virus”, virologist and flu expert Robert G. Webster, examined whether another pandemic was possible. “The answer is yes: it is not only possible, it is just a matter of time,” he wrote. However, it is unlikely that anyone could have foreseen public liberties being suspended, cities being shut down and face masks as commonplace merely a year later. Furthermore, a public projection of the current reality – that borders would be sealed, airports would become ghost towns and schools would be closed – would have been met with global disbelief.

“Risk calculations have become more complex with increased globalisation, and in times like this, quantifiable risks are frequently followed by unknowable uncertainties.”

Regardless of Covid-19, uncertainty surrounds every investment decision, and to accept doubt is a sign not of foolishness, but of intelligence. No-one knows what the future holds with absolute certainty, but we must make decisions anyway.  An analysis undertaken by Didier Sornette of the Swiss Federal Institute of Technology Zurich is revealing regarding risk. It suggests that certain types of extreme events – known as dragon king events – can be predicted and prevented by picking up minor shifts. Sornette understands the crucial difference between risks that can be modelled probabilistically and uncertainties that cannot. In Radical Uncertainty: Decision making for an Unknowable Future, Kay and King argue the best way for investors to stay resilient is to plan for different futures using various approaches.

However, the random nature of the Covid-19 pandemic is problematic and the market has become the world’s most consequential guessing game. Decision-making is challenging when the playing field is always changing, and the current situation is exacerbating this. Professor Philip Tetlock studied the track records of acknowledged experts for over twenty years. His work highlights that the capacity of experts to make impartial forecasts becomes clouded by the quantity of data they have.

There is no single perspective of the world about which we could learn from past experience and use to conclude future behaviour definitively, and Covid-19 is a wide-ranging stress test for most business models. Collaborating across teams, instead of relying on the misleading certainties offered by algorithms or all-encompassing probabilistic risk models, offers some optimism.

According to Taleb, there are more situations in which a single variable – a virus, a cybersecurity fault, a natural disaster or a geopolitical row – can result in enormous ramifications. The Covid-19 pandemic has intensified the risks innate in the complex supply chain system, and the impact on the economy has been catastrophic.  GDP has fallen dramatically, with record broad-based falls in output for production, services and construction, and there is growing uncertainty over how fast economic activity will regain lost ground. The magnitude of the recession caused by the virus is unprecedented in modern times.

Risk calculations have become more complex with increased globalisation, and in times like this, quantifiable risks are frequently followed by unknowable uncertainties. An event like Covid-19 amplifies the risks inherent in the supply chain system.  In 2015, Ian Goldin, an Oxford University professor, warned in his book “The Butterfly Defect” about the risks of a global pandemic. Unfortunately, not everyone was listening and the systemic risk to the health, financial and infrastructure systems is still present, and with new technologies ever evolving, risk management will have to keep up.

Resilience does not depend on predicting the future (which is nay on impossible), but more about preparing for various situations, and a vital benchmark in an age of uncertainty is the aptitude to adapt when situations change. Flexibility and an ability to accommodate fluctuations should be the cornerstones of asset management from now on.

Managing risk in 2020 may drag on corporate confidence, but we have seen time and time again since the financial crisis, that certain investments can deliver returns even in the most challenging environments. The world is changing and offering opportunities, and in spite of Covid-19, investors should still have the utmost confidence in generating returns from their savings.