Donald Rumsfeld is a polarising figure, hero of the US political Republicans and a mad, bad imperialist warmonger of the highest order to the left (he was a chief architect of the second Iraq invasion).
He became a figure of fun however when at a press conference he explained, at considerable length and to increasing hilarity, the Knowns and Unknowns of the US military strategy of the time.
To paraphrase his discourse, he broke it down into 4 boxes.
- The known knowns
- The known unknowns
- The unknown knowns; and
- The unknown unknowns
One can only imagine a conversation between himself and the mighty George ‘W’.
Anyway whilst Rumsfeld’s explanation of the above degenerated into high comedy he did and does make a serious and worthy point and it is relevant today in financial markets and global economies.
THE KNOWN KNOWNS
- QE and artificially low interest rates are still in place to offset the effects of the financial crisis
- The very high levels of debt in 2008 have been significantly transferred from business and individuals to Sovereign balance sheets (governments)
- Western economies have experienced a significant bounce back in stock market valuations and property prices
- Debt markets (sovereign and corporate) are at historically low yields
- The massive, unprecedented central bank easing of money supply and rates can’t go on forever
THE KNOWN UNKNOWNS
- Exactly what is now happening in economies and with asset prices and exactly why, there is no past data to model, no play book, no reference material. This is new and untested stuff and it’s known that how it all fits together in terms of cause and effect is unknown
- How the process can be successfully wound down, many believe it’s not known
THE UNKNOWN KNOWNS
(This was the one that really started the rot for poor Donald)
The difference to a known unknown is that an unknown known is something that becomes clearer and in fact is known as time goes on or in retrospect, it’s just not something that was known to be known at the time (what ?????)
Ok so I find it easiest to think of it like this.
Let’s say a group of humans lived in the mountains and none of them knew that humans could swim.
Humans don’t obviously need to spend time in water so this is quite feasible.
Stuff happens which means they can’t stay where they are so the group travels down the mountain and comes into a valley that no one has ever seen before, arriving at a deep river that they have no choice but to cross.
They stop and they ask themselves, can we float across or will we sink and die? We don’t know.
The unknown known of this scenario is that actually humans intuitively know how to float and swim, it’s just not known to the group that this is the case.
ie : An unknown known ……… ta da!!!!
So in a financial world context this is the argument of central bankers currently when asked to explain how they intend to reverse their current policy actions in a benign way with positive outcomes when they are in unknown territory.
Their response (especially from Fed chief Ben Bernanke) is that as time passes much more will become clear (known) and that they will know (we will be able to swim, you just don’t know that yet).
This is a skilful use of the impossible to counter “faith” gambit, that any evidence contradictory to the particular article of faith in question is in fact a test of that faith on the path to its ultimate validation and so therefore must be completely ignored.
This is unbeatable as it allows for everything which does not confirm something to be automatically dismissed and it has indeed been the single most effective group control mechanism in all recorded history.
These can be if they are negative the real nasties, the stuff of nightmares, armageddon time.
When risk and volatility is modelled the chances of outcomes occurring are expressed in terms of standard deviations from the norm, the greater the standard deviation spectrum the greater the risk and volatility implied.
These quant based algorithmic calculations are all fine and dandy as far as they go but they fundamentally look at what has passed and only usually give a set of possible outcomes from that historical data.
The problem therefore is when one asks, well what happens if something that hasn’t happened before happens? There’s nothing in your model for that.
The response to this will be, well, duh!, if it hasn’t happened we can’t model it and anyway theoretically literally anything CAN happen so that’s infinite in possibility and therefore pointless.
To put this in a personal context I was in my younger days fond of allowing myself to get extremely miffed about something fairly minor and staying in said state for a considerable time.
This changed however one day when talking to a cosmologist and the subject of meteorites come up (from memory a small one had passed quite close to earth at the time).
I made some flippant comment about not being worried as we would have time to send up astronauts and nuclear devices to alter the course of any large bits of rock on a collision course with us, just like in the films.
He laughed (giving me the same sort of kindly look a parent has when their young child has just stuffed a large number of crayons up its own nose) and he explained that in fact there was about a 99% chance that we would become aware of an impending impact no more than about 5 minutes before it happened, and that even if it was a smallish one the effects could be cataclysmic.
This formerly unknown unknown piece of information fundamentally changed my thinking on having prolonged hissy fits, I thought, well if I am potentially 5 minutes from nothingness at any given moment then spending them seething about which of my daughters had used my razor seems sort of wasteful.
The serious point about unknown unknowns especially in today’s financial world is that as much as anyone says they know something, they only know it based on the assumption that what has passed will repeat.
Once you take away the mental Valium of restricting cause and effect to a maximum deviation of the norm, and instead understand that there is no real, actual normal then the full implications of the power of the unknown unknown is evident.
In fact I have offered to send a t shirt to any client who emails in to say they finished it, it will have the slogan “I know u know” on the front and a picture of a Badger with its head up its own backside on the reverse.
The point of writing it however is this.
The portfolios have had to date a stellar year and markets continue to hear the music of QE and cheap money so they continue to dance.
We are richer, we are happier, all is good today.
But I know we don’t know what happens when the music starts to wind down and worry that we are unaware that we don’t know things we need to know to be safer.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.