Golfing With a Chance of Rain
As a golfer who makes just a couple of great shots per round, I place significant weight on the weather forecast . In particular, because golfing in the rain makes a challenging game exponentially harder, the possibility of precipitation (POP) is what I consider before reserving a tee time..
From experience, I know that I can place less weight on the POP for a day that is a week away than one within 24 hours. This is because the POP variability is higher the further out we look but decreases proportionally with time. In other words, a 50% POP tomorrow has a far higher confidence level and more predictable range of outcomes, than a 50% POP a week from now. In Thinking in Bets, Annie Duke anecdotally touches on a couple of basic concepts used in some aspects of investment analysis. One of these ideas is that a better decision can be made if uncertainty is incorporated into a forecast. Framing possible outcomes, along with the confidence level around those outcomes, will help investors better incorporate uncertainty.
When considering the return outlook for most asset classes, for example, we typically use the average as the future estimate. Usually, this future estimate lies within a range because we cannot know with certainty what it will be. Given that the future is uncertain, instead of thinking of the expected average as a specific number, like the historical average, an alternative way to think of it is as a range itself. A market or an asset class rarely delivers its mean return, so thinking of the expected mean as a range is helpful. This way, one can include uncertainty into the estimate of the future mean and then incorporate variability around that future mean range. The individuals at Blackrock have succinctly described risk as the range of outcomes around the average and uncertainty as outcomes for the average.
Consider the uncertainty for the average return of investment-grade fixed income relative to most hedge funds. Fixed income as an asset class will almost certainly have a lower dispersion of returns and more certainty when estimating its future average. This will lead to a narrower (i.e., more precise) estimated future mean range. Uncertainty when estimating the future average range will not only vary by asset class but will occur within an asset class itself (e.g. A micro-cap vs. large-cap equity).
Incorporating uncertainty has implications for both asset selection and portfolio construction. If the volatility of an asset’s return data is exceptionally high relative to its sample mean, forward-looking estimates can be very imprecise. As an investor, if offered a choice between two investments with comparable risk and return, most of the time, one should choose the investment where there is a greater conviction in the mean return because we will have a higher likelihood of estimating its expected mean range correctly. Also, an individual is generally more objective when uncertainty is incorporated into an estimate. This means one is more likely to include conflicting information, if introduced, and make a more informed decision.