Investing in Unknown and Unknowable

Capitalism and Society

Volume 1, Issue 2 2006 Article 5

Investing in the Unknown and Unknowable

Richard Zeckhauser∗

∗

Harvard University

Copyright c 2006 The Berkeley Electronic Press. All rights reserved.

Investing in the Unknown and Unknowable∗

Richard Zeckhauser

Abstract

From David Ricardo making a fortune buying British government bonds on the eve of the Battle of Waterloo to Warren Buffett selling insurance to the California earthquake authority, the wisest investors have earned extraordinary returns by investing in the unknown and the unknowable (UU). But they have done so on a reasoned, sensible basis. This essay explains some of the central principles that such investors employ. It starts by discussing “ignorance,” a widespread situation in the real world of investing, where even the possible states of the world are not known. Traditional finance theory does not apply in UU situations. Strategic thinking, deducing what other investors might know or not, and assessing whether they might be deterred from investing, for example due to fiduciary requirements, frequently point the way to profitability. Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop real estate or new technologies. Those who lack these skills can look for ”sidecar” investments that allow them to put their money alongside that of people they know to be both capable and honest. The reader is asked to consider a number of such investments. Central concepts in decision analysis, game theory, and behavioral decision are deployed alongside real investment decisions to unearth successful investment strategies. These strategies are distilled into eight investment maxims. Learning to invest more wisely in a UU world may be the most promising way to significantly bolster your prosperity. KEYWORDS: investing, unknown, unknowable, sidecar investment, fat-tailed distribution, Buffett, Kelly Criterion, asymmetric information...