![]() So in order to think about the future and about risk, we must learn to quantify. The world is a place where “bad outcomes” are only “bad” if you know their (rough) magnitude. Which leads to an important second point: Uncertainty about the future does not necessarily equate with risk, because risk has another component: Consequences. So you must make the decision: Are you comfortable if that one thing happens, whatever it might be? Even if it only has a 1% probability of occurring? Echoing the first lesson of biology, Warren Buffett stated that “ In order to win, you must first survive.” You have to live long enough to play out your hand. Learning to adjust probabilities on the fly as we get new information is called Bayesian updating.Īlthough the future is certainly a probability distribution, Marks makes another excellent point in the wonderful memo above: In reality, only one thing will happen. This is the most sensible way to think about the future: A probability distribution where more things can happen than will happen. Knowing that we live in a world of great non-linearity and with the potential for unknowable and barely understandable Black Swan events, we should never become too confident that we know what’s in store, but we can also appreciate that some things are a lot more likely than others. Key point number one in this memo is that the future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution. How do we deal with this in a pragmatic way? The investor Howard Marks starts it this way: That introduces great uncertainty into the future, no matter what type of future you’re looking at: An investment, your career, your relationships, anything. Way more things can happen than will happen. You wouldn’t call walking down the street a “risky gamble” right? There’s no gamble at all.īut the truth is that in practical reality, there aren’t many 100% situations to bank on. If I told you there was a 100% probability that you’d get hit by a car today if you walked down the street, you simply wouldn’t do it. Doesn’t that capture it pretty well?Īnother way to state it is: If there were only one thing that could happen, how much risk would there be, except in an extremely banal sense? You’d know the exact probability distribution of the future. We found it through the inimitable Howard Marks, but it’s a quote from Elroy Dimson of the London Business School. “Risk means more things can happen than will happen.” The best colloquial definition of risk may be the following:
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