John Kay

Rethinking Risk: Uncertainty and Investment Returns

Author: John Kay Core Abstract: In modern finance, “risk” is often mistakenly equated with “volatility.” This article argues that true risk is not the fluctuation of stock prices, but the collapse of an investment thesis caused by “Radical Uncertainty.” Investors should abandon their obsession with probabilistic models and instead focus on narrative logic and systemic resilience.

1. The Fundamental Difference Between Risk and Uncertainty

In finance textbooks, risk is typically defined as the standard deviation of returns (volatility). However, this definition only applies to a “Small World” (such as a casino or actuarial insurance). In the real “Big World,” we face Radical Uncertainty.

• Resolvable Risk: Events where you can calculate the probability of occurrence based on historical data.
• Radical Uncertainty: Events where you neither know the probability nor can you even enumerate all the possible outcomes. This type of uncertainty cannot be “captured” by mathematical models.

2. Why Volatility Is Not Risk

For long-term investors, severe short-term price fluctuations do not constitute risk.

• The Transience of Volatility: As long as the company’s fundamentals (the narrative) remain unchanged, price will eventually converge with value.
• True Risk is the “Permanent Loss of Capital”: This usually stems from the disintegration of a business model, not a shift in market sentiment.

3. Ask the Right Question: “What is going on here?”

Since predictive models fail, how should we make decisions? John Kay suggests that instead of calculating probabilities, we should construct a “Reference Narrative.” When facing an investment decision, investors should stop staring at discount rates in Excel and instead ask:

“What is going on here?”

This requires understanding:

• What is the underlying technology driving industry change?
• Is the management’s decision-making logic consistent?
• Is the system resilient under extreme pressure?

4. Strategies for Uncertainty: Resilience and Adaptability

In a world of radical uncertainty, perfect “Optimization” does not exist.

• Resilience: Ensuring the system does not collapse entirely when hit by unforeseen shocks.
• Adaptability: The ability to quickly adjust the narrative logic and take action when the environment changes.

Conclusion: Reshaping the Investment Outlook Investing is not a game of probabilities; it is a marathon of insight. We must accept the fact that “the future is unknowable” and shift our energy from predicting price movements to understanding the evolutionary logic of enterprises within complex systems.

Deep Dive: “Radical Uncertainty” (2020)

Co-authored by John Kay and Mervyn King (former Governor of the Bank of England).

• The Critique: A “scorched-earth” critique of modern financial risk models, specifically the “Chicago School” of economics, which assumes all uncertainty can be transformed into “risk” by assigning probability distributions.
• Core Logic: In the real world, we face “unknown unknowns.” You cannot assign a value between 0 and 1 to the “exact probability of the next pandemic” or the “specific impact of AI on society 20 years from now.”

The Four Pillars of “Rethinking Risk”

1. Risk vs. Uncertainty: Risk is like a roulette wheel (known outcomes/probabilities). Uncertainty is ignorance of the future. Kay notes that risk is often negative (failure), while uncertainty is two-sided (potential for alpha).
2. Rejecting the “Bell Curve”: Traditional models assume returns follow a normal distribution. Kay argues reality is Non-stationary—the environment and human behavior change constantly, so historical data cannot predict future “Black Swans.”
3. Reference Narratives: Ask “What is going on here?” Risk is any event that breaks your growth logic for a company, not the volatility of its share price.
4. Resilience: Since the future is incalculable, the best defense is not “optimizing a model,” but “increasing resilience.”

The Synergy with James Anderson

James Anderson has frequently mentioned that the opportunity for long-term investors exists precisely because most market participants (especially quant funds) mistakenly treat volatility as risk.

• Volatility is Noise: For both thinkers, if you hold a great company (like NVIDIA or Tesla), a 50% drop in stock price is volatility; true risk is the total loss of the company’s core competitiveness.
• Hunting for Outliers: Kay’s theory provides the intellectual foundation for Anderson’s high-conviction, concentrated style—in a world of radical uncertainty, only a few highly resilient and expansive companies can navigate the fog.

Depth Comparison: John Kay vs. Nassim Taleb

While both Kay and Taleb (author of The Black Swan) fiercely criticize modern finance, their “cures” differ:

Philosophical Divergence

• John Kay: Construct a “Reference Narrative.” Since models fail, our only weapon is a rational story. Investment Application: James Anderson focuses on the “Big Narrative” (e.g., Is AI changing the foundation of computing?). If the story holds, price swings are irrelevant.
• Taleb: Pursue “Antifragility.” You don’t need to understand “why.” You just need to survive and profit from the chaos. Investment Application: The Barbell Strategy (90% safe, 10% high-risk/high-reward). He prefers options to profit from extreme volatility rather than betting on a single company’s logic.

Summary: Where does James Anderson stand?

James Anderson leans closer to John Kay. While he appreciates Taleb’s “Fat Tails,” Anderson’s style is “High-Conviction Holding based on deep insight.” He believes that through academic research and understanding founders, one can identify the exceptional firms capable of harnessing radical uncertainty. This is “Offensive Long-termism,” whereas Taleb’s antifragility is more of a “Defensive-to-Counterattack” structural design.

Recommended Resources

• Article: “Rethinking Risk: Uncertainty and Investment Returns” (Interview in Baillie Gifford’s publication, Trust).
• Podcast: John Kay on The Money Maze Podcast.
• Books: Other People’s Money, Obliquity, and Radical Uncertainty.

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