Love him or hate him, Donald Rumsfeld probably summed up living in the information age better than anyone else in his century. In a February 2002 press conference the Secretary of Defense stated:
Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.
Rumsfeld’s unknown unknowns captured the anxious essence of his time. A country reeling from the largest economic downdraft in a decade was then spun into global conflict post-911, and people needed answers to the unknowns. In 2007, as the economy again started to deteriorate, former options trader Nassim Nicholas Taleb took the concept further when he popularized exploring the unknown through his black swan theory. Taleb offers that it is our natural human tendency to rationalize unexpected events only in hindsight. The weight of such significant surprises requires an equally powerful narrative for us to make sense of it all.
Indeed it is the unknown unknowns and the black swans that shape the world we live in. Over the past two years, no analyst, talking head, investment guru or yours truly anticipated oil falling from $100 to $30, the TSX falling from 15,600 to 12,700, or the Canadian dollar dropping from 1.03 to 0.70. And right on cue, today there’s no trouble finding the black swan narratives explaining it all in hindsight: the Chinese economy slowing, Iran bringing more oil on to the world markets, negative interest rates propping up slowing growth. By equal measure, trust that today’s predictions about where the market goes and what happens next are just as valuable as they were in 2014, zip.
It seems our only line of defense against the unknown unknowns and black swans is to remember a very simple piece of four hundred year old math called the Law of Large Numbers. Cardano, an Italian mathematician, was first to prove that the results of any experiment become more accurate the more times the experiment is performed. In simple terms, the more we observe something, the better judgements we can make about it. For example, if we flip a coin ten times, we might possibly see heads every single time and conclude a coin toss always results in heads. But if we flip that coin ten thousand times, the Law of Large Numbers gives the true answer, half heads and half tails. That’s important because we know that over time, the extremes fade away, and we’re left with the status quo. There’s no need for black swans and no need for making predictions.
That’s good news this very moment because the law of large numbers is an investor’s most helpful friend.
Based on one hundred years of market observations, we know that not every single company with high cashflow will create a good result, but most will. We also know that not every single company with a positive trend will keep moving higher, but most will. We know that not every single low volatility company will stay that way, but most will. We know that not every single cheap company will increase in price, but most will. We know that not every 20% decline recovers quickly, but most will. And we know that not every month will be profitable, but most will.
While we listen to the stories and articles trying to turn irrational chains of events into investment narratives, keep faith that the law of large numbers always wins in the end. That is a known known.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.