By: Grover Grafton
In equity investing, there isn't a more costly mistake than confusing uncertainty with risk. This is a mistake no one can afford; So, lets break it down. But first a few definitions (As I see them).
Risk = The probability of any Permanent loss of capital.
Uncertainty = The dispersion of potential future outcomes.
When these two get confused, as is easily done, things often get thrown out that, when viewed properly, offer great opportunities.
To properly evaluate any asset you must deliniate these characteristics in you mind and gauge them separatley.
Here are the steps in my thought process:
Ask yourself, "What's the worst and best situation that might occur?" This measures the breadth of uncertainty. The bigger the gap between the best and worst-case scenario, the more uncertainty. If you find yourself unable to predict the best and worst scenarios, throw it in the "Too Hard Pile".
Most securities spend the majority of their time in the "Range of Reasonableness" where, given the best and worst situation, they trade at a price that will deliver an average market return. This is, however, decreasingly true the more uncertainty there is (the bigger the aforementioned gap).
Given you're reading this to gain an edge and stocks with average uncertainty yield an average return, we want to be looking for highly uncertain low-risk situations. Where there is an easily determined but massive gap between the best and worst scenarios and the market has discounted the asset to an unreasonably low valuation (in relation to the worst-case scenario) due to its irrational confusion between risk and uncertainty.
Given all this, above-average returns are found when a stream of cash flows from a equity shares (company) or other assets are highly uncertain (as defined above) but can be purchased at a price that results in a low probability of permanent capital loss.
This gap between probable worst scenarios value for a security and the price at which a security is purchased is your margin of safety, dictating your return and whether a bet is low risk.
Summary:
High Uncertainty / Low Risk is "Where the Fi$h Are".
