Richard Zeckhauser’s Investing in the Unknown and Unknowable (.pdf) is a fantastic 2006 paper about investing in “unknown and unknowable” (UU) situations in which “traditional finance theory does not apply” because each is unique, so past data are non-existent, and therefore an obviously poor guide to evaluating the investment.
Zeckhauser gives as an example David Ricardo’s purchase of British government bonds on the eve of the Battle of Waterloo:
David Ricardo made a fortune buying bonds from the British government four days in advance of the Battle of Waterloo. He was not a military analyst, and even if he were, he had no basis to compute the odds of Napoleon’s defeat or victory, or hard-to-identify ambiguous outcomes. Thus, he was investing in the unknown and the unknowable. Still, he knew that competition was thin, that the seller was eager, and that his windfall pounds should Napoleon lose would be worth much more than the pounds he’d lose should Napoleon win. Ricardo knew a good bet when he saw it.
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The financing of 36 million pounds was floated on the London Stock Exchange. Ricardo took a substantial share. His frequent correspondent Thomas Malthus took 5,000 pounds on Ricardo’s recommendation, but sold out shortly before news of the Waterloo outcome was received. The evidence is clear that Ricardo, in his words, understood the “dismal forebodings” of the situation, including “its consequences, on our [England’s] finances.”
Zeckhauser’s Table 1 below shows the UU world:
Zeckhauser says that many great investors, from David Ricardo to Warren Buffett, have made most of their fortunes by betting on “UUU” or unique UU situations:
Ricardo allegedly made 1 million pounds (over $50 million today) – roughly half of his fortune at death – on his Waterloo bonds.5 Buffett has made dozens of equivalent investments. Though he is best known for the Nebraska Furniture Mart and See’s Candies, or for long-term investments in companies like the Washington Post and Coca Cola, insurance has been Berkshire Hathaway’s firehose of wealth over the years. And insurance often requires UUU thinking.
Not all UU situations are unique:
Some UU situations that appear to be unique are not, and thus fall into categories that lend themselves to traditional speculation. Corporate takeover bids are such situations. When one company makes a bid for another, it is often impossible to determine what is going on or what will happen, suggesting uniqueness. But since dozens of such situations have been seen over the years, speculators are willing to take positions in them. From the standpoint of investment, uniqueness is lost, just as the uniqueness of each child matters not to those who manufacture sneakers.
These strategies are distilled into eight investment maxims:
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Maxim A: Individuals with complementary skills enjoy great positive excess returns from UU investments. Make a sidecar investment alongside them when given the opportunity.
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Maxim B: The greater is your expected return on an investment, that is the larger is your advantage, the greater the percentage of your capital you should put at risk.
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Maxim C: When information asymmetries may lead your counterpart to be concerned about trading with you, identify for her important areas where you have an absolute advantage from trading. You can also identify her absolute advantages, but she is more likely to know those already.
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Maxim D: In a situation where probabilities may be hard for either side to assess, it may be sufficient to assess your knowledge relative to the party on the other side (perhaps the market).
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Maxim E: A significant absolute advantage offers some protection against potential selection. You should invest in a UU world if your advantage multiple is great, unless the probability is high the other side is informed and if, in addition, the expected selection factor is severe.
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Maxim F: In UU situations, even sophisticated investors tend to underweight how strongly the value of assets varies. The goal should be to get good payoffs when the value of assets is high.
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Maxim G: Discounting for ambiguity is a natural tendency that should be overcome, just as should be overeating.
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Maxim H: Do not engage in the heuristic reasoning that just because you do not know the risk, others do. Think carefully, and assess whether they are likely to know more than you. When the odds are extremely favorable, sometimes it pays to gamble on the unknown, even though there is some chance that people on the other side may know more than you.
The essay is brilliant. Zeckhauser acknowledges in the conclusion that it offers “more speculations than conclusions,” and its theory is “often tentative and implicit” in seeking to answer the question, “How can one invest rationally in UU situations?” but, if anything, it’s the better for it. Thinking as Zeckhauser proposes about UU situations may vastly improve investment decisions where UU events are involved, and should yield substantial benefits because “competition may be limited and prices well out of line.”
Read Investing in the Unknown and Unknowable (.pdf).
h/t @trengriffin via @mjmauboussin
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