Ignore knowable knowns at your own peril

By DAVID MOON, Moon Capital Management, LLC
April 15, 2012

In explaining risk to a group of reporters, former defense secretary Donald Rumsfeld differentiated between types of known and unknown risks, noting that the most dangerous risks are those about which we are incapable of even knowing exist.

Although Rumsfeld's model generally holds true in financial affairs as well as geopolitical ones, even knowable known risks can pose unanticipated losses.

Some friends of mine recently had their house burglarized. It happened in the middle of the day, by thieves skilled in their illicit craft who left some, but little, immediate obvious evidence of their intrusion. Among other things, the thugs took laptop computers, a BB gun and jewelry. The value of some of the jewelry was primarily sentimental; a grandfather's watch or engagement ring cannot be replaced. Other pieces of the jewelry can be relatively easily replaced with an insurance check and a trip to Markman's.

Except that even this thoughtful, intelligent, presumably well-prepared couple wasn't properly insured for the jewelry. The loss of the contents of their house was a knowable known potential loss. They bought insurance. They updated their replacement cost policy limits as the value of their house increased.

But buried in the little print of the onion skin legal policy, written by an actual, legitimate insurance company, was a clause that limited their payments for jewelry loss to $1,000. You don’t have to be Elizabeth Taylor to exceed that figure, which they did.

This couple did everything right – or so they thought – and yet they still experienced a several thousand dollar avoidable loss.

So will some people reading this column. Why?

For some people, like my friends, it will be the result of honest, but avoidable, lack of knowledge. Although few people likely realize all of the specific limits in their homeowner’s policies, it is knowable. (I had some surprises when looking mine up this week.)

Some people will experience avoidable losses because they are lazy or unorganized. They will get around to checking their policy – next week.

And some people will unnecessarily lose money because they are stupid. They conclude that bad things happen to other people and choose to ignore the known knowable risks. In most cases we owe them the honor of living with their decisions.

This model of Rumsfeld property and casualty risk management also applies to your investment portfolio.

The unknowable unknowns are always the most risky, because they are impossible to hedge against. By definition, they are impossibly to anticipate. Quit worrying about them.

Knowable unknowns may be unlikely, but they are at least contemplatable. Will the US suffer a decade long drought or a nuclear winter caused by a massive asteroid that hits rural Alabama? Or, slightly more plausibly, what about a collapse of commodity prices in the US? Most of these you can simply ignore. Most.

But ignore the known and knowable knowns at your own peril. Neither inflation, nor stock prices will remain in their current ranges forever. Bond yields can go up. Gold prices can go down. Tax rates will increase. And decrease.

And you probably have more jewelry in your house than your homeowner’s policy covers.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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