Manage investments under extreme uncertainty

How to think about risk when there is extreme uncertainty?

Risk management under extreme uncertainty should be approaches by thinking about the balance between uncertainty and commitment. We think this way of thinking is more useful than the classical risk assessment frameworks.

This paper focuses specifically on making commitments and investments in high risk countries. These are countries with high levels of uncertainty, often with violence and armed conflict.

In this article we present some of the core ideas developed with our clients.

In this case, the intellectual roots of this article stem from researchers at the Uppsala University. A series of studies on business and internationalization emerged from that University in the late 1970s. (1) There have since been several iterations and contributions. These are empirical studies trying to understand business investment decisions under uncertainty. We stand on the shoulders of giants.

On the back of their contributions, we have developed frameworks for clients to help them manage investments and portfolios that are implemented in places with extreme levels of uncertainty – or risk.

This is an action oriented approach. The focus is on the types of actions that can be taken to reduce risk. More so than the typical probability/impact framework that offers little guidance for how to deal with the risks.

The core idea: Risk is a function of uncertainty and commitment

A fundamental idea is that risk is inherently about the relationship between uncertainty and commitment.

The more uncertainty, the lower the investment, for a given level of risk.

Or conversely, commitments can only be increased if uncertainty is reduced. The higher the commitment, the less uncertainty, for a given level of risk. High uncertainty=less commitment, low uncertainty=more commitment.

If your risk tolerance is increased, i.e the curve is shifted outward, you would then make higher investments with a given level of uncertainty.

Another key idea is that commitment decisions can be controlled internally, while managing uncertainty requires external action. Deciding whether to invest, and indeed the level of commitments, is a decision that can be largely controlled internally. At least more so than the uncertainty in the external environment.

The exhibit below illustrates the core concept.

Exhibit 1: Illustration of the risk function

How to manage risk uncertainty by deliberately strengthening the knowledge base

The key idea is that uncertainty can be impacted by knowledge development.

Knowledge reduces uncertainty. This makes uncertainty contingent on knowledge. You can take action to impact it.

There remains “pure” uncertainty, that is unpredictable, and that cannot be managed.

The question is then how to reduce uncertainty and gain knowledge?

Our clients typically implement two strategies for knowledge generation that contribute to reducing the uncertainty.

Exhibit 2: Illustration of strategies to reduce uncertainty by building knowledge

First, and perhaps most important to establish a knowledge base, is the generation of relational- and experience based knowledge. This can be about establishing contacts and relationships. In environments where institutions and rule based behaviors are less prominent, building relationships becomes the dominant strategy to gain knowledge, and thereby to reduce uncertainty.  Also, organizations build knowledge through participating, and gaining experience through sustained exposure over time. This reduces uncertainty and allows for more significant investment commitments. The risk frontier is effectively shifted out.

For example, businesses report these types of intangible assets as very valuable. To the extent that they are very reluctant to reduce investment commitments in the event of higher risks in the environment. They prefer to stay in the game so that they will not loose the opportunity to reengage. There is no on-and-off switch for relational knowledge.

These types of intangible knowledge assets also constitute a significant barrier for investing on the frontier. Similarly, public organizations; aid, diplomatic and intelligence organizations invest considerably in these types of knowledge assets, perhaps more so than in formal and codifiable knowledge products.

Second, there is formal and structured knowledge search. In high risk countries, there is often little codified knowledge available. This increases the risk of strategic misdirection and project design failure.

A key challenge in countries with high level of uncertainty and conflict is that little formalized knowledge often exists. The quality of the knowledge available is also often questionable. There are three types of formal knowledge problems:

• Available formal knowledge may often have poor validity, as the limited information le may poorly represent the problem. Data availability in post-conflict countries is extremely limited, and standard methods of gaining quantitative insights from i.e purchasing market data, viewing economic statistics, will not hold.
• Knowledge may be unreliable. There may be minimal quality control in government, in academia and from other sources. There are few opportunities for verification and triangulation.
• Limited availability. Some is public and some is proprietary. Corporate produced knowledge is largely kept confidential for competitive reasons. Much of the publically produced knowledge efforts are developed by international agencies, i.e World Bank, IMF and the bilateral aid agencies, but less is available from domestic sources. The availability of public products vary, perhaps less than it should be, but are generally more accessible to investors than proprietary materials. Note for example that statistical economic information presented by International Financial Institutions is largely based upon government information with all the quality issues that may represent.

Exhibit 3: challenges with formal knowledge on the frontier

2. Approaches to managing risk under uncertainty

From this, we can derive two strategic approaches for managing risks under high levels of uncertainty.

(i) Build gradually with an investment perspective that has long time to maturity; and

(ii) Portfolio approach, seeking to balance uncertainty and commitment across the portfolio

(i) Build gradually with long time to maturity

If the aspiration is a significant commitment, whether in private or public goods, the recommended approach is to start small. Such investments may have considerable long time to maturity, more so than in structured environments, and much because the uncertainty is so high.

By making directed efforts over time, in relationships and knowledge products; pure uncertainty is reduced and more significant investments can be made.

For example, large scale infrastructure such as national identify systems, may require years of gradually building relationships and technical feasibility understanding before the big money is committed.

Exhibit 4 Illustration of investment approach with long time to maturity

(ii) Portfolio approach balancing uncertainty and commitment across

For those who manage more complex portfolios, an approach with several different initiatives, across different stages, can serve well in balancing uncertainty and commitment.

This can be illustrated in a matrix as shown in the exhibit below. We identify four different concepts that can be managed across the portfolio.

• This is for investing in high uncertainty situations, with the principal aim of acquiring relations and build experience. Investment levels are small. These types of activities should be managed by high capacity organizations to ensure directed effort and maximized learning.
• Small commitments under less uncertain situation. Principal difference is that the situation may be understood, but there is limited experience with making commitments. These can be managed by more local organizational elements.
• These are the high risk/high reward scenarios. High uncertainty prevails, yet the impact of investments can be considerable if successful. A balanced portfolio could contain a few tigers. These needs to be managed by highly qualified and high capacity elements of the organization.
• Big Bets. These are when the situation is well understood. Much knwoeldge has been developed over time, and there is finally an acceptable level of uncertainty to make the big commitment. In a mature portfolio, this would constitute the largest share of the investments. Local level organizations may have been developed to manage these investments.

Exhibit 5 Portfolio approach to managing risks under uncertainty

Pleased to discuss

By Ivar Strand. Managing Partner @abyrint.