Former US Treasury Secretary Robert Rubin outlined four principles for decision-making under uncertainty, in his famous 2001 Harvard commencement speech. These principles are valuable for the financial communities. Robert Rubin is best known for managing financial crises, including the Mexican peso crisis (1994-95), the Russian debt crisis of 1998, and the Asian financial crisis (1997). He also promoted open trade policies, advancing U.S. integration into the global economy and strengthening economic ties with international partners.
1. The only certainty is that there is no certainty.
While this principle is often cited, it is rarely embraced. In investing, uncertainty and risk are distinct. Investors face uncertainty, where the distribution of outcomes is unknown, while casinos deal with risk, where outcomes follow a known distribution. For example, business fluctuations are uncertain, whereas gambling outcomes are risky.
Overconfidence often leads to poor decisions. Investors should consider a broad range of possible outcomes, as unexpected events can occur. Experience and overconfidence can negatively impact investment choices.
2. Rubin’s second principle is to base decisions on weighing probabilities.
For instance, when deciding whether to cross a busy road with a 70% chance of safety or wait for a 95% chance at the traffic light, one must weigh the likelihood of each outcome against the potential cost of error.
For example, if analysts estimate a 70% probability that a stock will exceed earnings expectations, leading to a 20% price increase, and a 30% probability of underperformance resulting in a 30% price decline, the expected value is (0.7 x 20%) - (0.3 x 30%) = 5%. This does not guarantee a 5% return each time, but over many similar investments, the average return would be 5%. Rubin advises focusing on risk tolerance and potential consequences, rather than expecting certain returns.
According to SEBI, about 91% of individual traders in the equity derivatives segment lost money in FY25, yet many continued trading. But should this data be taken as a red flag? The real story is in how much money a trader makes in the 9% of the option positions that are profitable to him. The advisability of owning options depends on the returns from the 9% profitable positions and, an individual’s risk tolerance. Without weighing these probabilities, one cannot reach a conclusion on his derivatives trading strategy.
3. Despite uncertainty, we must act.
In a rapidly changing world, most decisions must be made with imperfect or incomplete information. Rubin recommends making decisions through careful evaluation of all available data, regardless of quantity. He emphasises the “yellow pad” method, in which all possible outcomes are listed, assessed, and cost-benefit analyses are conducted. This approach helps focus on key information and disregard irrelevant details.
An important aspect of decision-making is evaluating the depth and significance of primary data compared to supplementary data. Supplementary information should meaningfully support and strengthen the primary data used in making decisions.
4. Judge your decisions not only by results, but also by how they were made.
Here, price and value are pitted against each other. What is the price we have paid for the value we have observed or the value we hoped to see? But before we dive into price and value, we must understand that there is no guarantee that good decisions will lead us to a good outcome, and that bad decisions will only lead us to a bad outcome.
We, retail investors, carry lifetime stigma of failure when some of the primary investment decisions we had taken fail. To overcome this, Ruben recommends not relying on a single outcome but considering multiple outcomes when making a decision, so that one can mitigate the risk of excessive focus on a particular scenario.
Rubin emphasizes probabilistic thinking, avoiding outcome bias, and focusing on the decision-making process. Two cognitive biases that can undermine decisions are the confirmation trap and anchoring. Investors should avoid seeking only information that supports their existing beliefs and be cautious not to rely too heavily on initial information, as anchoring can cause them to overlook subsequent developments.
Rubin goes on to say, "It's not that results don't matter. They do. But judging solely on results is a serious deterrent to taking risks that may be necessary to making the right decision. Simply put, the way decisions are evaluated affects the way decisions are made."
~~FINE~~
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