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Japan Earthquake Shows the Difference Between Uncertainty and Risk in Investing

The recent events in Japan provide another reminder that so much of stock returns are due to surprises. They also provided us with a reminder that while investors typically think about investing in stocks in terms of risk, investing is actually much more about uncertainty than risk.

There's an important distinction between risk and uncertainty:

  • Risk exists when probabilities are known.
  • Uncertainty exists when we can't calculate the odds.
For example, we know the risk of a roll of the dice. On the other hand, examples of uncertainty would be the chance of another attack such as the one we experienced on September 11, 2001, or of the recent series of revolutionary events in the Middle East. Unfortunately, investors often confuse the two concepts. The following is an example of confusing risk with uncertainty.

An insurance company might be willing to take on a certain amount of hurricane risk in Dade and Broward counties in Florida. They would price this risk based on approximately 100 years of data, the likelihood of hurricanes occurring and the damage that they did. But only a foolish insurer would place such a large bet that the company would go bankrupt if more or worse hurricanes occurred than had previously ever been experienced. That would be ignoring uncertainty -- that the future might not look like the past.

Individuals often make a similar mistake, causing them to decide on an equity allocation that exceeds their ability, willingness and need to take risk. They tend to view equities as closer to risk where the odds can be calculated precisely. This tendency is strongest when economic conditions are good. Their "ability" to estimate the odds gives investors a sense of confidence. That drives down the equity risk premium demanded by investors. And that drives up equity prices.

However, during crises investors perception about equity investing shifts from one of risk to one of uncertainty. We often hear commentators use phrases like: "There's a lack of clarity or visibility." Since investors prefer risky bets to uncertain bets, when the markets begin to appear to investors to become uncertain, the risk premium demanded rises -- and that's what causes severe bear markets.

The historical evidence is very clear that dramatic falls in prices leads to panicked selling as investors eventually reach their GMO point -- the stomach screams "Get me out!" And selling begets more selling. Investors have demonstrated the unfortunate tendency to sell well after market declines have already occurred and buy well after rallies have long begun. The result is that they dramatically underperform the very mutual funds in which they invest. Also, the stocks they buy underperform after they buy them, and the stocks they sell go on to outperform after they are sold.

The reality is that investing in equities is always about uncertainty, not about risk. In fact, that's exactly why the equity risk premium has been so high. Investors demand a large risk premium to compensate them for taking uncertain "bets." Those investors that recognize this will avoid the mistake of taking more risk than the have the ability, willingness or need to take. By avoiding that mistake, investors give themselves the greatest chance of also avoiding the mistake of letting their stomachs -- and not their heads -- make investment decisions. Stomachs rarely make good decisions.

More on MoneyWatch:
How the Japan Earthquake Is Hurting Commodities' Returns TIPS Update for March 2011 5 Reasons to Avoid Variable Annuities How John Bogle Changed the Investing World Quest for Alpha: 10 Rules for Being a Successful Investor
Three ways I can help you become a wiser investor:

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