Known Risk, Knowable Risk, and Unknowable Risk

Risk Managementphoto © 2009 Jeff | more info (via: Wylio)
This post may hit on a more philosophical note than usual, but it is a reality that no matter where you go or what you do with yourself or your money there is some kind inherent risk. What’s a guy or gal to do about risk? I think of risk in 3 buckets: Known, Knowable, and Unknowable.

Known risk – This is actually the easiest risk to cope with for most people for 1 reason. It’s controllable. You can do qualitative and quantitative risk analysis with known risks. You can make millions doing this, even if you get it really wrong – just talk to Moody’s about the risk on mortgage loans! Personally, I try to control for known financial risk using proper diversification and moving to more conservative assets as I age. I use common sense and always spend less than I make so I am always saving. The same goes for life. I don’t drive without a seatbelt. I don’t have unprotected sex with HIV+ partners. I don’t climb shaky ladders or pet strange dogs either. These are all quantifiable and avoidable risks.

Knowable risk – These may be the toughest. You don’t know these risks right now, but they are knowable. I try to mitigate through education. I read voraciously and try to stay up to date on recent research and trends. As I gather data, more risks can become known so I can move it to the Known bucket and manage it accordingly. A recent example of this is Apple stock (AAPL). The risk associated with Steve Jobs’ health was an unknown last week, but over the weekend he announced he was stepping down for the time being. This risk became known and investors responded accordingly. On the Monday open, AAPL opened $20 lower than its Friday closing price. Investors obviously saw increased risk in owning shares. However, other investors quickly began buying the shares. Within a few hours, AAPL had risen $15 off the open. Obviously where some investors saw new risk, others saw the reaction as new opportunity. I was in the later bucket and picked up a few shares on the cheap, but it’s all a matter of risk tolerance (and time horizon). At least it’s one more thing we can add to the Known risk bucket

Unknowable risk – It is by definition unknowable and will always be present in some form. It’s a sunk cost associated with participating in life. Small bits of the unknowable may eventually become knowable, but focusing on risk that is 100x harder to figure out than Knowable or Known risk is a giant waste of time. For this risk I drink a couple of glasses of red wine each night, get a nice buzz on, and watch the Daily Show.

It’s actually a bit like a variation on the serenity prayer: I strive to accept the risks I can never know, mitigate the risks I know, and develop the ability to understand the difference.

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  • Steve

    A great article. A shorter version of it was in the Readers’ Comments to the article “The One Big Catch With Retirement Investing” in the New York Times, January 21, 2011

    I like the metaphor of risk in 3 buckets: Known, Knowable, and Unknowable.

    But, I especially like the part about “drinking a couple of glasses of red wine each night, to get a nice buzz on,” in reference to “Unknowable Risk.” Very sensible.

  • Thanks Steve. The NY Times article inspired the comment, and then the comment inspired me to expand on it a little more. More so that I could understand my own thinking. I didn’t really write this post to generate traffic. Sometimes those are the best posts though.

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