The uncertainty trap

“I honestly believe it is better to know nothing than to know what ain’t so.” - Josh Billings 

Uncertainty is a fact of life. It permeates every part of our existence and cannot be avoided. We face uncertain health, business prospects and ups and downs in our environment. Today’s blog is about what uncertainty does to us, why we sometimes end up with bad outcomes under uncertainty and what practical steps we can take to reduce its negative impacts. Comfort with uncertainty and reducing terrible outcomes are common ways people build their ability to weather storms.

Different types of uncertainty

There are different types of uncertainty:

Outcome uncertainty: There are set outcomes with predictable probabilities, but you would not know for sure what the outcome of 1, 10 or 100 dice rolls will be.

True uncertainty: Not only is the outcome uncertain but the range and probability of outcomes are uncertain too. This might be because:

• It is impractical for you to know everything

• There is not enough history or data out there for you to analyse

• There are fundamental reasons to think that the world will look different going forward and therefore analysis of history is not appropriate

• Each of your key inputs is itself highly uncertain; for example, trying to predict inflation might require you to understand the oil price, which might need you to understand the duration and severity of the US/Israel/Iran conflict

• Whilst the impacts might be able to be modelled, the second-order behavioural or policy responses often cannot

Dealing with uncertainty

The grandfathers of behavioural science, Kahneman and Tversky, showed that people will pay for certainty. Even in everyday parlance we talk about “a bird in hand is worth two in the bush”. We see this behaviour in the over-use of insurance and guarantees, or in not taking enough investment risk in savings portfolios.

We also prefer risks we have taken before over taking new risks; for example, staying in a relationship or role longer than we should, because we overweight the risk of trying something new. We see this with reducing risk premia in new asset classes as people turn from unfamiliarity to familiarity.

A similar but related thing we see is a need for cognitive closure: a desire to reach a firm answer and remove ambiguity. People who are most in need of cognitive closure make small decisions quickly and try to reduce situations to orderly and predictable framings. Whilst this might be advantageous in some situations, in others it can be an issue, as a need for closure can make people reluctant to review previous decisions and therefore rigid in their decisions or modelling assumptions. This becomes a problem if they need to explain away lots of “idiosyncratic” data or automatically distrust things that disagree with their framing. The COVID pandemic was a very challenging environment for those with a high need for cognitive closure, as the risk and severity were hard to relate to in terms of whether we should be very worried or not worried at all.

How discomfort with uncertainty leads to bad outcomes

Discomfort with uncertainty can lead to four types of poor outcomes:

Inaction: Delaying, deferring, “just one more piece of analysis”, “one more approval”. It is hard to argue against prudence, but it is often prudence dressed up as fear. Often inaction can mean sticking with an old decision that you cannot unpick, or not killing off a failing project.

Panic: You need to be done with the feeling of fear and act quickly simply because doing nothing feels unbearable. We see it in panic selling at market lows. The feeling of action gives people agency even if it does not improve the outcome. Often in markets an uncertain situation causes more of a downward shift in prices than when that situation actually plays out; in other words, people may value a known bad situation more generously than an uncertain one.

Safe bets: Convince yourself you are taking action but grab the safest bet. A safe-looking job, government bond or loudest narrative because you cannot deal with the discomfort of being undecided.

Outsource certainty (aka self-deception): Taking advice is often the right thing to do, but sometimes there is genuine uncertainty. Rather than accept that uncertainty in our own minds, we pay overconfident, and wrongly incentivised, people to transform an uncertain situation into a certain narrative. That is one reason why people living through a challenging situation are more likely to use tarot card readers. These overconfidence tricks help people collapse uncertain situations into an unjustified “it will happen” or “it will not happen”, i.e. false precision.

Improving our outcomes under uncertainty

The obvious first point is: do the work. Understand and think through what you could do and how that might help or hinder your situation. That means looking at what has happened and trying to be reasonable and realistic.

The rest of it is really about working with the uncertainty and getting ourselves to a place where we can take deliberate and thought-through action, which might include doing nothing:

Act on imperfect information: You will never have all the information you want. Also, nothing great can happen to you if you do not take action. The trade-off between those two truths is the essence of a well-lived life.

Think through the downside: One of the best ways to decrease the discomfort of downside scenarios is to face them head on. What would you do if you lost your job, or the investment lost money instead of making money, and what would that actually look like? Would that be as catastrophic as you felt before thinking it through?

Avoid fragility: Many terrible outcomes are not caused by uncertainty alone. They are caused by uncertainty meeting fragility. Whether it is an overstretched balance sheet, an unaffordable lifestyle or an overwhelmed mind. In markets, financial leverage can turn a manageable setback into a forced-seller moment. If you can manage your portfolio, bank account or mental health to a more resilient place, it will allow you more breathing room during uncertain periods. For others, insuring against very bad outcomes, by having a rainy-day fund or using insurance, allows them to take risks knowing they have a cushion to land on if they fall.

Know which decisions to spend cognitive load on: Two types of decisions should not be obsessed over. Small or one-off decisions, where the benefit of analysis is not justified, and reversible decisions. With small decisions we can shop around and save ourselves £5 but with an unacceptably high cognitive load, and with reversible decisions, action is less consequential and can be reviewed later, with more information.

So what?

• Uncertainty (like death, taxes and cold calls) is one of life's permanent features

• The aim is not to eliminate uncertainty, but to get better at managing it. Most bad decisions under uncertainty come not from the unknown itself, but from our discomfort with it.

• We freeze, panic, settle for safe bets or outsource conviction because ambiguity is emotionally expensive.

• Better judgement starts with accepting that we will often need to act before we have all the information we want and thinking properly about the downside helps us get our arms around the situation.

• Avoiding fragility matters more than pretending to predict every possible outcome.

• In markets as in life, optionality and room to manoeuvre improves resilience.

The people who tend to do best are not those who always know what will happen next, but those who can stay thoughtful, solvent and deliberate while it unfolds.

Next week, will be "Technology and uncertainty". As always get the blog delivered directly to your inbox on Home | Deciders | for mental fitness | change your mind.