The Known – Unknown Dilemma
"There are known knowns. There are things we know we know. We also know there are known unknowns. That is to say, we know there are some things we do not know. But there are also unknown unknowns, the ones we don't know we don't know." These words were spoken by Mr. Donald Rumsfeld in 2002 as the US Secretary of Defence on the limitations of intelligence reports and have eventually been deep pearls of wisdom that could be applied in different walks of life, such as for refining our investing-risk compass. It can be an effective mental model as part of our investment decision making process that can provide us the elusive clarity of mind which all of us constantly seek.
In every investing scenario, there are four possibilities: Known Knowns, Known Unknowns, Unknown Knowns and Unknown Unknowns.
Known Knowns: This is the most obvious of the lot wherein you know what is known to others. In that case there are no surprises for an Investor, and she can take informed calls.
E.g.: One knows that a company is burning capital at a unit economics level and therefore has an arduous journey to cover in achieving Product-Market Fit and subsequently generating free operational cash flows. An investor can accordingly make decisions to avoid or mitigate the identified risk.
Known Unknowns: This involves knowing what one does not know. It is a classic case of self-awareness when you know what your blind spot is. Accordingly, an Investor can do her homework on the possibilities and move ahead.
E.g.: A fintech company discloses the First Loss Default Guarantee (FLDG) that it has provided to a lender. The impact of loan defaults (NPAs) on this fintech company are not known. An investor understands the nature and probabilities of the potential liability and assesses the likely impact. Accordingly, she can take a calculated risk.
Unknown Knowns: This is the most appalling of the lot because it involves information asymmetry i.e. what is unknown to you is known to someone else. As investors we need to avoid this risk because we will never get compensated for it. And in our knowledge one of the ways to tackle this is to extrapolate – what can go wrong and to what extent?
E.g.: In the previous point, you realize that the disclosed potential liabilities (arising out of the FLDGs) are itself a significant red flag, then what about the operational aspects that have not been disclosed and can go wrong. As an investor one needs to hold a healthy scepticism to extrapolate downside possibilities, so that one is only subscribing to mis-pricing risk rather than mis-information risk.
Unknown Unknowns: This is what we are going through today. Who would have predicted the varied uncertainties (Pandemic, Russia-Ukraine war, subsequent livelihood and supply chain disruptions and resulting recessionary conditions) and their impact on our lives, businesses and investments? This is the tail risk that we don’t speak about much. It mostly remains beyond our control and therefore needs to be dealt with in different ways. We think the answers lie in the classic investment tenets of asset allocation, diversification and long-term orientation.
Here is a quick snapshot of this framework that we can use through our investment decision making process:
In sum, we can be mindful of these two points as we build our investment portfolios:
Knowing the nature and extent of ‘Known Unknowns’, knowingly taking the risk of ‘Unknown Knowns’ is futile.
‘Unknown Unknowns’ are as good as anyone’s guess, and so it’s important to be shielded from them as much as possible.