A hedge fund manager friend passed along an article written by a Harvard Behavioral Finance professor — Richard Zeckhauser — that deals with making decisions in cases that are unknown and unknowable. It originally appeared in Capitalism and Society, an open journal published by Columbia University.
Compared to the facile conception of risk embraced by most academics and enshrined in the Capital Asset Pricing Model (CAPM) as well as in option pricing models, I find Zeckhauser’s view of risk to be innovative and informative.
While not mathematically heavy, this paper has a lot of nuance to it and should probably be read multiple times. Zeckhauser offers three hypotheses (speculations) and a few maxims, and I think his hypotheses do a good job of explaining the overall flavor of the piece:
- UUU investments – unknown, unknowable and unique – drive off speculators, which creates the potential for an attractive low price.
- Individuals who are overconfident of their knowledge will fall prey to poor investments in the UU world. Indeed, they are the green plants in the elaborate ecosystem of finance where there are few lions, like Bill Miller and Warren Buffett; many gazelles, like you and me; and vast acres of grass ultimately nourishing us all.
- [Unknown and Unknowable] situations offer great investment potential given the combination of information asymmetries and lack of competition.
As you can see from point 2 above, Zeckhauser makes favorable mention of Bill Miller, an investment manager who beat the market for 15 years running. Miller’s reputation did take a big hit during the 2008-2009 financial crisis, and his rise and fall underscore one of Zeckhauser’s maxims:
The greater is your expected return on an investment, that is the larger is your advantage, the greater the percentage of your capital you should put at risk.
Miller had a highly-concentrated portfolio of banks, homebuilders, and retailers, all of which had the same underlying driver (levered consumers’ desire to spend money) and all of which collapsed simultaneously. Miller bought more of these assets as the market continued to fall, and was eventually forced out of the company he had made famous, Legg Mason.
While it’s important to take heed of Miller’s cautionary tale in the context of investing in Unknown and Unknowable situations, Zeckhauser makes some very good points in this essay that I personally will try to apply to my own decision-making process.
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