Illusion of certainty
How likely is God? «67%», says one scientist*.
What nonsense! The probability that God exists cannot be calculated. On the other hand, we can easily calculate the probability that a roulette ball will fall on seven or that we will win the lottery.
With roulette and lotto, we operate in a world of complete certainty. The risk can be calculated. Statistical thinking and logic are enough.
As an investor during a stock market crash, as well as a tennis player with a match ball in hand, we operate in a world of uncertainty.
In an uncertain world, not everything is known. Data is scanty and constantly changing. The best alternative and its probability of success can therefore not be calculated.
In a world of uncertainty, complex models fail. They mistakenly assume known risks and provide exact probabilities. This accuracy creates a dangerous illusion of certainty:
In 1998, hedge fund LTCM, with two Nobel laureates on board, relied so heavily on its quantitative arbitrage models that it operated with a high leverage of 25. The ruble crisis triggered a flight to safe havens, leverage exploded to over 200, and the fund collapsed. Its manager launched a new fund shortly thereafter, raised $250 million, used the same strategies as LTCM – and failed again in the 2008 financial crisis.
In an uncertain world, logic and mathematics are not enough.
Such models only work if everything takes its usual course, if past trends continue. They fail exactly when it matters: in the ruble crisis, the subprime crisis, the euro crisis, the Corona crisis, during liquidity squeezes.
Therefore, a model that almost correctly represents reality does not necessarily make almost correct forecasts. It can still produce complete nonsense. This is because many factors have to be estimated under such great uncertainty that enormous, uncontrollable estimation errors result. The model becomes too unstable.
So the greater the uncertainty, the more we should simplify.
A combination of simple rules of thumb combined with experience, knowledge and intuition – i.e. unconscious intelligence – of the decision makers, promises better results.
Such rules of thumb do not rely on predictions. Their consequences can be easily assessed even by laymen: “stocks perform better than bonds in the long run”, “a stock market crash of more than 50% is a buy signal”, “keep enough liquidity for three years”.
Transparency leads to more safety. Complexity to disasters.
Conclusion: The more uncertain a situation and its outcome, the more you should trust intuition and rules of thumb, while putting models aside.
* Dr. Stephen Unwin in “The Guardian”, March 8, 2004.
Background information for those interested:
Kay, John; King, Mervyn (2020): Radical Uncertainty: Decision-Making Beyond the Numbers. W. W. Norton & Co.
Gigerenzer, Gerd (2014): Risk Savvy: How to Make Good Decisions. Viking Hardcover.
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