Unknown Unknowns

Skilfully concise and pretty darn illustrative though this statement actually was, its validity was almost completely marred by the sensitivities of the subject it sought to explain.

But if we extricate ourselves from the morality of it all, and look at the statement pragmatically, it is not difficult to see the myriad applications of this seemingly muddled observation. 

It has reams of applications in the world of investment, however, the temptation is to assume that every major stock market correction has not been predictable, and therefore driven by unknown unknowns, or ‘Black Swan’ events.

But that isn’t the case.

The unravelling of the Dot.Com boom was relatively model-able, although I am not suggesting the timing and magnitude could have been predicted. What I am saying is that history has shown rampant and indiscriminate buying of stocks is often a precursor for a rather large pop. In short, it was known that the market was probably overcooked, but the unknowns were the ‘when’ and the ‘how big’.

Conversely, the September 11 attacks and subsequent market sell-off were so far outside the realm of typical expectations that they surely must have been an unknown unknown. No model could have predicted it.

I would argue that a more likely method of forecast might have been human intuition, but this in itself would have been next to useless as the details would have been completely, well, unknowable.

The reason for my pondering all of this is the continuing uncertainty caused by the Russian occupation of Crimea. At the outset it caused volatility in global markets, although there was no crash by any means (with a nod towards the magnified effects it had on Moscow’s bourses), and I find myself wondering whether this sort of thing is a known unknown, or an unknown unknown.

Escalation was quick, and I don’t think anyone, bar a few, would have identified this as an area of concern but a few months ago. That being so, Russian / Ukrainian tensions can be traced back to the fall of the U.S.S.R and beyond, so a dispute isn’t exactly from the leftfield.

Because markets, rightly, tend to focus on fundamental indicators like inflation, corporate earnings, economic growth, jobs reports and so on, I wonder if they take their collective eye off geopolitical events to a certain degree, or at least place less emphasis on their importance.

Save for a few instances, the onset of any conflict does tend to trigger volatility that feels like the result of surprise as much as uncertainty, especially when there are natural resources involved, as in the Crimean case. 

The upshot of this could be that, no matter what the event, there is always an element of the unknown. Businessmen would tell you that no matter how sound the plan is, with large projects there is always such a risk. Successful sports teams are always open to being outdone by an opponent playing above themselves on that particular day.

It is delusional to think that the economic world is entirely predictable, and further it is very risky to ignore the potential for unpredictable events to occur. There will always be things that we don’t know we don’t know but just because you can’t foresee the event nor predict the date or magnitude doesn’t mean that you can’t take steps to mitigate its effects. This underlines the absolute necessity of diversification, monitoring and rebalancing on an ongoing basis. It is not enough to remain static and staid, no matter how Swan-proof you think your strategy is.

nicholas.williams@brewin.co.uk

Nick Williams is an Assistant Director at Brewin Dolphin and offers advice on a wide range of financial services to private clients, trusts, charities and pension funds.  

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