One thing I am certain of is that, in recent years, investors have talked a lot about “rising uncertainty”. While it undoubtedly feels that way, it is not always clear what we actually mean when we say this – isn’t the world always uncertain? Because it is not obvious what this uncertainty consists of, it can be difficult to know what to do about it.

Any conversation about uncertainty needs to begin with the idea of risk. The two terms are often treated as synonymous, but they are different – and that difference matters.

Risk can be thought of as any situation where there is more than one potential outcome, with each outcome carrying a known probability. The classic example of a “pure” risk scenario is rolling a six-sided die. It has six possible outcomes, each with an equal probability of occurring. Crucially, this scenario contains no uncertainty.

Why is there no uncertainty? Because we are sure of the possible outcomes and their associated probabilities. As soon as we lose confidence in what those future paths might be, or how likely they are, uncertainty emerges.

Of course, there are very few things in life – outside of structured games – that involve risk without uncertainty. Human existence is inherently uncertain.

So, if virtually everything is always uncertain, is it ever fair for investors to say that things are becoming more uncertain?

I think it is, and there are two forms of “rising uncertainty” that investors care about:

1. Greater doubt about the probabilities attached to future outcomes. We are comfortable with our model of the world, but are less confident about how likely any given outcome is occur. There is more variability within the model.
   
   
2. Greater doubt about the model itself. It’s not just that the probabilities within our existing framework are volatile; it’s that the framework we use to understand the world may no longer apply.

The first case is what we might call “normal uncertainty”. For example, in a stable economic and political regime, an investor still cannot predict the future with any consistency, but the mental model they apply captures the broad range of outcomes reasonably well.

The second case is “model uncertainty”. This occurs when a political, market or economic regime undergoes a profound shift or shock, leaving us unsure about which model is appropriate in the first place.

Consider an extreme example. Imagine yourself making economic and market projections about a developing country – applying a model based on the structure and stability of a regime that has been in place for fifty years. You can never be certain of the outcomes, but you are comfortable with the parameters. This is “normal uncertainty”. If, however, there is the real possibility of revolution and regime change, you face a more troubling problem: you cannot be confident that the model you are applying will remain appropriate. That is “model uncertainty” – and it is harder to deal with.

When investors talk about “rising uncertainty”, they often mean this latter version (although the two are closely related). Current concerns span multiple areas: the behaviour of the Trump administration, rising populism, a shifting inflation regime, and the changing shape of globalisation. The worry is not simply about calibrating the old model, but whether that model has become flawed or obsolete.

(When I refer to “models”, I do not mean formal, technical models – just the mental frameworks we use to interpret how the world works.)

Although the world almost inevitably feels more uncertain, it is important to remember that financial markets are always inherently uncertain. That is why political, economic and asset-class forecasts are so consistently wrong. We have not suddenly moved from a predictable environment to an unpredictable one. Over the past century we have lived through enormous social, political and economic shifts, and major asset class returns have held up well through these.

That long-term resilience, however, does not mean that such environments are easy for investors. They are not. They create profound challenges – many of them behavioural. If there are genuine concerns about how the world is working, what should we do about it?

Ignore soothsayers

The more uncertain we feel, the more we will be sold products and services promising to navigate it for us. Funds that adapt to all market conditions or research that claims unique insights for a new world will become common. These may seem like appealing antidotes to discomfort, but we should be sceptical. If the future is genuinely more uncertain, adding more predictions is not a sound solution.

Avoid concentration

In an uncertain world, we have less confidence in the path ahead. Concentration by stock, fund, asset class or theme becomes particularly dangerous. If we don’t know where we are going, we should avoid heavy exposure to any single scenario.

Accept the “cost” of diversification

The dangers of concentration can be offset by the prudence of diversification – holding assets that will perform well in different scenarios. This sounds simple but is psychologically difficult, because we dislike holding assets that look like laggards. Good diversification in an uncertain environment means being comfortable owning assets that would have performed better in worlds that did not occur.

Be wary of risk models

Even though we know that “all models are wrong, but some are useful”, we often overweight the “useful” part when it comes to risk models and downplay the “wrong”. This is understandable – in uncertain environments we crave tools that offer comfort – but that comfort is often illusory. This concern is especially acute when uncertainty is more of the “model” variety: a risk framework calibrated to the old world may give precise-looking answers to questions that are no longer the right ones.

Focus on ‘gravitational’ factors

Even in an uncertain backdrop there are elements of investing that tend to work through time – those with a fundamental gravitational pull. These include the yields we receive, the valuations we pay and the cash flows that compound over time. These forces are more likely to work regardless of which future unfolds.

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The world and financial markets are always unpredictable; that is nothing new. There are, however, periods when it feels as though the rules of the game have changed. Whether that proves to be true matters less than thinking carefully about the behaviours required to navigate such environments well.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

At any given point in time, there is one major investment risk that becomes the focus of everyone’s attention. Sometimes this will be a new and significant event (such as the war in Iran); other times it will be a risk that has lain dormant but suddenly becomes the thing to care about (like the recent AI/software company flare-up). The problem is not just that we almost always end up misjudging the impact of these risks, but that there is an incessant stream of them. Many investors seem to manage their portfolios from one risk to another, month by month, quarter by quarter. Suffice to say, this is probably not a strategy that can be successful over the long run.

As humans, we tend to judge risks by their availability – that is, we assess the severity and likelihood of a risk based on how prominent and emotive it is. It is easy to see the evolutionary benefit of this: if you worried a lot about very obvious threats, you probably had a better chance of survival.

While this focus on available risk may be a very effective human adaptation, it is incredibly unhelpful for most investors. There are two major problems. First, our tendency is to hugely exaggerate the risks we face at any given moment. This is particularly pertinent for long‑term investors, as there are simply not many risks that are likely to matter in a predictable way over the horizons we care about. Second, given that we cannot know how any particular risk will unfold, it is incredibly difficult to do anything useful about it. What should we do? Get out of the market until the next risk comes along and then see how we feel?

The other issue with availability is that it creates a conveyor belt of risks, where one salient concern is in focus at any given point in time only for another one to come along the following month. Not only is the world far more complex and interconnected than this would suggest, but focusing on one particular risk means we are not considering many others.

For an investor, the next geopolitical risk feels far more vital than the risk of, say, trying to time your equity exposure or selling out of equities altogether. We are only wired to care about one of these – the thing that is front and centre right now, which is making us feel something.

We also tend to act as if the risk that currently has our rapt attention is far more important than whatever was on our minds six months ago, which we can barely remember. We struggle to imagine that we will be worrying about something else with similar intensity in a few months’ time.

Although how some risks come into central focus is obvious – the current situation in Iran being a good example – others seem to become the topic everyone cares about out of the blue. It can be an underlying risk that everyone has known about for a long time suddenly starting to feel vital.

Cass Sunstein and Timur Kuran wrote about this idea and defined it as an “availability cascade”. This is the process by which belief about a risk becomes acute because it is visible and frequently repeated. The spread is driven primarily by informational and reputational factors, which are self‑reinforcing.

How does this work? Imagine that during one balmy summer a diver is bitten by a shark off the coast of Cornwall. What happens next?

Informational cascade: News stories appear everywhere about dangers lurking in British waters. The incredibly remote risk of being the victim of a shark attack has not changed, but how we feel about it has.

Reputational cascade: You are taking your family to the beach in Cornwall. You know the risk of a shark attack from letting your children swim in the sea is virtually non‑existent, but you also know what other people might think. Haven’t you seen the news? Imagine the looks from the other parents as you lead your children into the water.

Availability isn’t generally about imaginary risks; it is about real risks being overstated because of how aware of them we are.

We see this exact phenomenon all the time in financial markets – in the emergence of bubbles and in sporadic panics about certain risks. We are bombarded with what seems like information and feel compelled to react because everyone around us is.

It is almost certain that the advent of social media and 24‑hour news has made these availability cascades more frequent and more impactful.

Managing an investment portfolio for the long term while reacting to each headline risk is not only exhausting but highly likely to lead to rash decisions and poor outcomes. There is no easy solution to this; the spectre of availability can make it costly to our reputation to ignore risks even when they are wildly exaggerated or imponderable.

For long‑term investors, the risks to meeting our objectives are far more likely to stem from our reaction to headline risks than from the risks themselves.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

You are standing at the top of an imposing hill. The descent is steep but a little craggy and undulating. In your hands is a basketball. You drop the ball and it begins its journey downward. Are you more confident in predicting that the ball will reach the foot of the hill, or the exact path it will take to get there?

I would hope that most of us are more confident in expecting gravity to take the ball to the bottom of the hill than anticipating the precise, chaotic course it may chart on its way. Yet many investors with long-term horizons are faced with a similar question and seem to prefer obsessing over the journey while losing sight of the end result.

We know the fundamental return drivers of traditional asset classes (particularly equities and bonds), and we can have a solid level of confidence that these will come to pass if our horizons are sufficiently long. Investors, however, often seem to ignore this and instead undertake the hopeless activity of guessing each erratic twist and turn along the way.

Most of us are spending time and money trying to predict exactly how the ball will roll down the hill.

Predicting Chaos

I recently saw a performance of one of my favourite plays – Tom Stoppard’s Arcadia. It covers a vast array of topics, but one of its central themes is the concept of chaotic systems. Valentine, a key character in the ‘modern’ element of the play, has this to say about chaos and the problem it creates for making sensible predictions:

“We are better at predicting events at the edge of the galaxy or inside the nucleus of an atom than whether it will rain on Auntie’s garden party three Sundays from now. Because it turns out the problem is different. We can’t even predict the next drip from a dripping tap when it gets irregular. Each drip sets the conditions for the next; the smallest variation blows the prediction apart.”

Valentine’s words say much about the futility of trying to predict financial market conditions. It is a deeply complex system (it has many, many moving parts), and it is chaotic (the behaviour of one component is highly sensitive to the change in another). Even with relatively simple systems — such as a ball rolling down a hill — it is incredibly difficult to predict variations and fluctuations. The sheer complexity of financial markets is staggering; it is a wonder that anyone attempts to forecast them at all.

We can have a reasonable level of conviction that equities will generate positive real returns over time because there are some fairly stable assumptions at play: economies will grow, companies will generate earnings, and those earnings will compound through time. Of course, the drivers of asset class returns are not as unimpeachable as gravity, even over the long term. But we can have far more confidence in them holding than we can in knowing what markets will do over the next year.

Irresistible Predictions

The ongoing conflict in the Middle East has created something of a prediction frenzy, as investors react to a salient reminder of how unpredictable the world is by trying to forecast a whole host of imponderable things.

Even if we create a very simple model of the world and try to predict how things will play out, we quickly see the superhuman level of foresight that is required.

To make a good investment prediction we would need to know the magnitude and duration of the war, its impact on oil prices, how it affects the global economy, the response of governments and central banks, and how financial markets might react to all of that.

This is an embarrassingly simple construct. It excludes a vast array of important elements and ignores new events that will inevitably occur in the future — events we are not yet even thinking about. Yet even with such a simplified model, we still wouldn’t have a clue how everything might unfold.

In a complex system, all the interactions between factors matter, and they all act on each other in unknowable ways. If you think you can do this well, you need to explain why and how.

Most investors are best placed taking a long-term view that the underlying fundamentals of traditional asset classes will come to pass over time. Rather than attempting the impossible — trying to forecast the fluctuations of those assets while we hold them — we should instead diversify our portfolio in a manner that allows us to withstand a wide range of potential short-term outcomes. This gives us the best chance of making the long-run work for us.

We don’t need to predict how a ball might roll down a hill to be confident that it will reach the bottom.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

From an investor’s perspective, one of the primary challenges in dealing with events such as those unfolding in the Middle East is that, in times of stress and uncertainty, we quickly default to our most human instincts. These instincts are almost always at odds with sound investment decision-making. We stop doing the things we know work and get lured back into doing the things we know don’t.

The things we don’t know:

• How the situation in the Middle East will develop.
  
• What the short and long-term geopolitical and economic implications will be.
  
• How actions in the Middle East will interact with a multitude of other relevant dynamics in the months ahead.
  
• How financial markets will respond to any of these developments.
  
• Which issue might be the focus of investor attention next month.

The things we do know:

• Even those with considerable expertise cannot hope to forecast the unfolding consequences of geopolitical events.
  
• Predicting the first, second, and third-order financial market impact is even harder.
  
• Short-term volatility in markets is unlikely to have a predictable impact on long-run outcomes.
  
• High real returns for holding equities over the long term are compensation for bearing short‑term volatility.
  
• At some point in the future, equity markets will decline sharply because of some unforeseeable negative occurrence.
  
• Humans often hugely overweight high-profile and salient risks.
  
• Humans make poor decisions when emotions are heightened.
  
• Diversification is the best protection against an uncertainty.

Managing our behaviour as investors is about subduing some of our most human urges – urges that are useful in many contexts but typically disastrous for long‑term investment decision-making. Yet in conditions of uncertainty and anxiety, the compulsion to take action, to predict the unpredictable, and to focus solely on the immediate future often becomes overwhelming.

When we most need to remember what we know, we tend to forget it.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.