A few weeks ago, I wrote a small piece on DCFs and I pointed out that risk and uncertainty need to be treated differently.
One of the most influential teachers for me was Prof. Amitava Bose. Prof. Bose taught macroeconomics at IIM Calcutta and famously set a final paper whose solution was 4 graphs. When I got my job in a VC firm out of IIM Calcutta, he sent me his much used and dog-eared copy of Frank Knight’s Risk, Uncertainty and Profit. I wasn’t particularly close to him personally which made the receipt of this unexpected package and a note with it even more special. He asked me in the note to read this book end to end at least twice, and to read it again whenever I struggled with an investment.
Written in 19211, the dense, dry volume is a testament to how original thought will continue to be relevant even after a century. I would highly recommend you read it if you have the time. Admittedly, it was written in a very different world. However, the book makes only one point: Genuine Profit opportunities can only arise in the face of Genuine Uncertainty.
Knight begins:
“It will appear that a measurable uncertainty, or “risk” proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We shall accordingly restrict the term “uncertainty” to cases of the non-quantitive type. It is this “true” uncertainty, and not risk, as has been argued, which forms the basis of a valid theory of profit and accounts for the divergence between actual and theoretical competition.”
Before we go further, maybe a quick stop at the Webster’s Dictionary website to check on the definitions:
Risk: “possibility of loss or injury; peril”
Uncertainty: “indefinite, indeterminate” and “not known beyond a doubt.”
A. Two Types of Uncertainty (one is called Risk)
When Outcomes and odds are known in advance.
When the Outcomes and therefore Odds are unknown.
Let’s take the staple construct of pretty much all probability classes - the two dice roll. Before we roll, we know that the probability of each number coming up. As far as games of chance go, it is pretty much as knowable as it can get. So, lets say I roll two dice a billion times. We know in advance that the probability of rolling a 4 or a 10 is ~8.4%, or that the probability of rolling a 7 is highest at 16.7%. In this construct, we can make high confidence forecasts. This is knowable uncertainty i.e. Risk.
Genuine uncertainty is different in that is is an unknown unknown. We don’t know the possible outcomes, let alone the odds for the same.
As an example - We don’t know if the ONDC framework in India will do anything at all or if it will mean game over for Amazon and Flipkart. We don’t know if EVs will take off in India, and we don’t know if Jet Airways will ever again take to the skies. Sure, there are enough pundits who will rely on historical analogues and try to project the future (like Zomato’s 2030 P&L), but forecasts tend to be overestimated in the short/medium terms and underestimated in the long term. Here is an example - How many people made the Long Apple / Short Nokia trade? The variance in prediction v/s reality is often massive.
B. Flawed Decision-making in a Confusing World.
We are for the most part, irrational decision makers. The Theory of Rational Expectations is a fundamental assumption for most work we do in the worlds of business or finance (even if we don’t know what it is called). It assumes that people will make rational decisions based on all available information, that markets will behave perfectly and with full liquidity and so on.
Here is the problem - we evolved to survive, not to make economic transactions. So when things are going south (like Jan 2008 or in March 2020), people are looking to survive. Moneymaking is an afterthought. Markets tanking by 40% is not rational, it’s a race for survival.
The key issue here is that we react to such bad situations. To act means to embrace the uncertainty. We substitute hard questions which require us to expend effort looking up and weighing facts and information with reactions based on most easily available information. Once your fight-or-flight reflex is engaged when you are sitting in a chair at a desk in front of a Bloomberg terminal - rational thinking is the first thing that goes out the window.
Kanehman Writes in Thinking, Fast and Slow:
“The world in our heads is not a precise replica of reality; our expectations about the frequency of events are distorted by the prevalence and emotional intensity of the messages to which we have been exposed.”
C. Uncertainty Drives Profits
I am going to go back to Knight here for a moment. He argues:
“The receipt of profit in a particular case may be argued to be the result of superior judgment. But it is judgment of judgment, especially one’s own judgment, and in an individual case there is no way of telling good judgment from good luck, and a succession of cases sufficient to evaluate the judgment or determine its probable value transforms the profit into a wage.”
What he is saying effectively, is that the entrepreneur (or investor) must embrace uncertainty. If we keep waiting for enough examples to give us comfort re. the uncertainty, the profit making opportunity is gone. Then one is simply managing risk for a wage. Risk is Knowable. Which begs an existential question
Why would an LP pay 2 and 20 for managing the knowable? Cant they hire a certified FRM professional and be done with it?
Uncertainty is critical for the functioning of markets. The very existence of the market depends on differing opinions. So, the markets have to make room for doubt, asymmetrical / fake / imperfect information and opinions. Think about it, if there is no uncertainty, who will take the other side of your trade?
D. Uncertainty Creates Alpha
Let me present a hypothesis. I believe that there are only a few markers that set a great PE/VC txn from a mediocre one. The ideal target does one of the following:
Resolve an inefficiency of an existing industry.
Expand a solution to a new segment/market.
Create a new market.
Now, if you are an investor, what will really interest you are 2 and 3 above. We are hoping to make investments where the returns will be 3x, 10x, 100x and so on. Unless the target business is really disruptive or transformational, the math just doesn’t work.
Think of some of the biggest and most profitable PE/VC deals and blockbuster exits that you may have read about. Now think of how those companies created Alpha2. Uber, Lyft, AirBnB, Ola, Zomato. These guys have created value where nothing existed. No competition, no comparables, unknown cost structures, no clarity on the rules of the game. And in effect, these companies wrote their own rules of their games. They defined new industries or completely took apart existing ones.
This is Uncertainty in action creating Alpha.
There are countless riffs on this thought in philosophy and pop culture. When Bruce Lee is advising us to be like water - he is really asking us to embrace uncertainty. To adapt to it, to make it work for us.
As someone who has met some of the biggest Unicorns of 2021 and evaluated them from an investment perspective, I can offer one insight - The best outcomes have happened when Absolutely, 100% Certain entrepreneurs have teamed up with highly Uncertain investors.
Most lucrative businesses are the ones that either create a new ecosystem or smash the current ones. In practice, a good trait correlated with an entrepreneur doing either of those things is their mission focus. If the guy believes he can change the world, he most likely will.
The Mission Focus of entrepreneurs is such a critical factor that it will be nigh impossible to overstate its importance. The guy we wish to back is the one who is not thinking in terms of probabilities but inevitabilities. By not focusing the risks, the entrepreneur will often reduce the investment decisions to binary outcomes - Massive Success or Massive Failure. The investor has to constantly evaluate the situation and identify what has changed from uncertainty to risk and help the entrepreneur address it. That makes for a good relationship. People focused on money are unlikely to create great or non-linear returns.
Conviction matters a lot. Conviction is embraced Uncertainty.
E. Personal Notes
In the end, Prof. Bose was right. Everytime I have read the book again, a new nuance has opened up, a new insight has struck, a new way of looking at facts/data has presented itself. But more importantly, it has forced me to look at whether I was dealing with Risk or Uncertainty. For the most part, I think I have embraced uncertainty, eschewed risk.
AmBose is gone, but he is still educating me.
Yes, it is a bit dense and by today’s conventions hard to read but it gives you an Aha moment pretty quickly and holds you.