The biggest threats to the economy and the markets tend to be the ones that pop up out of nowhere. In 2014 while everyone was worried about interest rates rising in the U.S., another totally unexpected threat arose in the global economy, the sharp drop in oil prices. This is what former Secretary of Defense Donald Rumsfeld called an “unknown unknown.” These totally unforeseen crises are also known in the business world as black swans, a term famously coined by Nassim Taleb, a leading expert in risk who warned of the 2008 financial crisis. Any threat that people are aware of is naturally less dangerous than a black swan. A true black swan comes out of nowhere and catches virtually everyone flatfooted.
Secretary Rumsfeld famously divided knowledge about the future into three categories. There are the known knowns: the facts we are certain about. Then there are the known unknowns: threats on the horizon that we have some awareness of though we don’t know when and where exactly they will strike. Then there are the black swans or “unknown unknowns,” the threats that can come out of nowhere. Some commentators have also added to Rumsfeld’s approach by observing that there are also “unknown knowns,” things that we might think we know that are actually false. Regardless of your politics or what you think about the Iraq war, the Rumsfeld’s framework is very helpful for thinking about risk.
This framework works for individual stocks as well as economies. I made the chart below to show how the Rumsfeld approach can help in thinking about risk in the stock selection process:
The goal in picking stocks using the Rumsfeld framework is to put as much information in the top two boxes as possible while minimizing what’s in the bottom two boxes. You want to know as many of the known knowns, the publicly available facts about the company as you can. You also want to learn as much as possible about the known unknowns, the threats lurking on the horizon. By adding as many things to the known unknown box as you can, you reduce the number of potential black swans. Once you think about a potential black swan, by definition it is no longer a black swan.
Similarly you want to try to recognize the “unknown knowns,” the conventional wisdom and the hype that is likely false. This box is particularly important during boom or bust periods when the nearly universally accepted opinions may be false. In the late nineties there was a great deal of hype about internet stocks that had little or no earnings. The thought was that the old rules of investing had changed and Internet stocks created an entirely new paradigm. Of course this turned out to be false. Then in the post-crash periods such as 2009, stocks seemed permanently out of favor, and no one wanted to buy them despite the fact that top quality companies were selling at a 50% discount. This apocalyptic sense also turned out to be mistaken as the market launched a six-year, nearly 200% rally.
The future is impossible to predict in any reliable or consistent way. However, I think my Rumsfeld chart is a useful tool for recognizing and minimizing as many potential risks as possible. To the really vigilant investor there should be fewer real black swans or unknown unknowns because he is always thinking about new threats on the horizon.