The Great Unknown

"We are now ready to start on our way down the great unknown. Our boats...are chaffing each other, as they are tossed by the fretful river.  We have but a month's rations remaining.  We are three quarters of a mile in the depths of the earth, and the great river shrinks into insignificance, as it dashes its angry waves against the walls and cliffs that rise to the world above; they are but puny ripples, and we but pygmies, running up and down the sands, or lost among the boulders. We have an unknown distance yet to run; an unknown river yet to explore.  What falls there are, we know not; what rocks beset the channel, we know not; what walls rise over the river,we know not." -   John Wesley Powell explorer 1834 - 1902

As humans we are constantly striving to uncover the hidden secrets of the universe.  Centuries have been dedicated just to answer questions such as what is the purpose of life, are there other civilizations out there and who am I?  There may never be an answer to any of these but it does not stop the human mind from questioning and probing.  So too in the world of finance people have for centuries tried to develop systems that take advantage of perceived market anomalies or try to remove the risk from investments through diversification.  Medicine too is constantly trying to extend our lifespan with new wonder drugs and treatments but in all of these one thing is very seldom considered - the great unknown.

Let's start with medicine.  Clinical studies are a very poor way to determine whether a drug is right for the final patient.  No two people are the same and no two people have the same diet or drug intake, all of which will have unintended effects for the taker of the drug.  Furthermore the methodology used drives the cost of the drugs to such heights that often the people most needing the drug are not able to afford them.  Finally, the testing process is short (and often riddled with one sided data) while sometimes the prescription period can be decades leading the patients into the great unknown as far as side effects and impacts on their health is concerned.

In finance it is the same.  Legions of "trained" financial experts continue to develop the next new product that will satisfy the masses required rates of return while limiting risk, providing a one stop shop where the lemmings can deposit their money and walk into the sunset and off the side of a cliff.  "Fortunately" the investment bankers are protected by the laws set up to protect the innocent and as long as they disclose properly (normally in such small font that the majority of people cannot read it and certainly way to complex to understand) and charge low fees they can advertise that they have the solution to everyone's investment problems!  Once again the problem is that these tools are not tested on real data but on past data (data mining or back testing it is called) that is easily manipulated and does not reflect reality or the great unknown.

In either of these examples the first thing to understand is that the great unknown will always be unknown.  There is no way to uncover its secrets.  Furthermore secrets that are uncovered reveal that there are more unknowns.  So worrying about the unknown is a waste of time, what your focus needs to be on is how to benefit from the unknown.  This is not an easy question to answer as how can you benefit from something that is unknown?

As this is a financial blog I will respond to this question by remaining in the world of finance but the answers can be transposed into any area that you like.  In finance the thing to realize is that there is no such thing as normal.  A "normal" return is absurd as the market is constantly changing.  Take for example interest rates.  Right now the "normal" risk free rate might be considered 2% but in the context of 100 years 4% might be a better proxy for normal but then again what do the first 50 years of the century have to do with me and was that period, which included world war one and two "normal"?  Looking back just 20 years and the Internet was in its infancy so why was that "normal"?  So if a normal rate of return is ludicrous then what you have to determine is your required rate of return and forget about everything else as it is just noise.

The next thing to understand is that the unknown will, at some stage, create havoc in the markets.  This is not an "if" but a "when".  Consider all the financial tinkering done by the world's central bankers and it quickly is clear that there will be a problem sooner or later it is just a matter of time.  Also believing that the central bankers of the world have the ability to avert the problem is naive at best.  In reality they are the biggest part of the problem as the more that they try to "protect" the more harm is done in the unintended side effect of the unknown.  In other words, the more they try to smooth out volatility the greater the volatility will be once it reappears.

So the key is to invest in a way that not only produces your required rate of return but benefits from the fragility of the financial situation.  As Taleb coined "Antifragile".  There are simple ways to start the process for example try to be debt free or even better keep some cash aside to buy when the markets crater again.  More creative is to purchase put options on positions with perceived large downside in weak markets or distressed debt on properties in solid economic hubs at pennies on the dollar to mention a few.  There are many more ways to benefit from the unknown but the investment style, risk and expected return need to be a good fit for the investor.  One thing is for sure; to ignore the great unknown is akin to financial suicide so make sure you review your investments in light of this outlier and rework it so that you benefit as that will be an abnormal return!