The quadrants of knowledge are helpful tools in risk assessment. I use them occasionally to assess how thin the ice is on which I stand. Because one thing is clear: while we cannot always know what is happening around us, I try hard not to have too much exposure in the worst quadrant. Because standing in the Quadrant of the unknown-unknowns is like falling into a black hole.
The quadrants of knowledge
The concept of quadrants of knowledge go back to a statement by United States Secretary of Defense Donald Rumsfeld:
Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know.
We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know.
And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult ones.
The whole thing sounds confusing and Donald Rumsfeld only mentioned three of our four quadrants. So let’s dive into it without further ado. To make it plain, the quadrants contain combinations of things we are aware of/unaware of and things we understand/do not understand.
So it’s always about two elements. One is the element of understanding and the other is the element of awareness. Four combinations/quadrants are possible.
The whole thing looks like this:
Let’s take a closer look at the individual quadrants:
The Known-Knowns
All is well in order with the world here. We are in a state where we understand everything and are aware of all developments, their causes, and drivers. Not much happens here, and when something does happen, the volatilities are not too great. Fat tails do not exist here. So we’re talking foot sizes, body sizes, the current weather, and time of day.
The Known-Unknowns
The second quadrant is about things we are aware of but do not understand. Here we are dealing with laboratory conditions. Most of the fight against COVID-19 took place in this quadrant. We were aware of a threat from a virus but did not understand its mode of action and its vulnerabilities.
The Unknown-Knowns
Donald Rumsfeld did not mention this third quadrant. Nevertheless, it is important as this quadrant is where most of our investing takes place. The quadrant is about all the things that we (would) understand but are unaware of. So the known is hidden behind the veil of the unknown.
The examples are manifold. For example, a person might suppress knowledge through trauma. Politicians may keep knowledge secret from society. An employee may be in possession of sensitive information but not share it. Or a company’s management may not share important information with shareholders.
The Unknown-Unknowns
In this quadrant, we are entirely lost. There is total hostility to life. We do not understand the world and are not aware of its characteristics. It is as if someone has thrown us into a black hole.
Why are the quadrants helpful tools?
The quadrants are helpful. In particular, they provide information on how far we can go with predictions.
In the first quadrant, for example, forecasts are pretty reliable. When a child is born, we can say with relative certainty that it will probably never reach a height of more than 2.20 meters. In a desert, we can say with great confidence that there will be no underwater world to marvel at for the next 5 to 10 years.
With the other quadrants, forecasts are more complex though. Things that we do not understand and are not aware of are subject to a high degree of uncertainty. Politicians or managers should rather not make predictions about when a virus will be defeated. Similarly, we should not make overly bold predictions about a company’s operating performance when we are not aware that the company is embroiled in an accounting scandal.
It is a simple heuristic. People in quadrants two to four should not make predictions. If politicians and managers had used this simple heuristic, they would have made themselves less vulnerable in the battle against the pandemic. Understanding these uncertainties is particularly important for one’s investment decisions. For example, investors without special insights into a company would make less of a fool of themselves with bold predictions and share price forecasts.
Investing and the quadrants of knowledge
I like to use the quadrants of knowledge for my risk management.
It should be clear to any investor that they are not in the first quadrant when investing. For me, that means I have to expect things I don’t understand or am not aware of.
- Things we don’t know, things we are not aware of (the known-unknowns): For example, we are not aware of the future. We cannot say whether the product of company X will still be in demand in 5 years. We don’t know if company Y isn’t already secretly working on a superior product. When Nokia continued to sell cell phones diligently, management was probably in the third quadrant.
- Things we do not understand (the unknown-knowns): These things include, for example, investments in companies that operate in certain regulatory environments. We may be aware of the unique nature of these systems, but we do not understand them and thus cannot evaluate them. Here, we are probably acting more in the second quadrant.
- Things we do not understand and are not aware of (the unknown-unknowns): Any investment can theoretically fall in here. For example, if we have done the wrong due diligence. Also, investments in individual Chinese companies fall into this category (but not investments in the entire Chinese market via an ETF), as I have shown in another article.
The quadrants of knowledge and risk avoidance
The quadrants are particularly useful for risk avoidance. As my readers know, risk avoidance is a critical element in my wealth management. I don’t look for the best possible performance. Investing is not a competition for me. All I want is inflation-adjusted preservation of my wealth and a cash stream flowing to me from it.
Accordingly, I do not presume to understand and be aware of everything. This protects me from rushing too much into a single investment, even if I am convinced of it.
In the third quadrant, we encounter things we are not even aware of. Here we can actively search for these things (we were not aware of initially). For example, backtesting and looking for negative results (“negative results” means finding results with negative effects) can bring to light manager promises not kept in the past (for the concept of backtesting, see here).
In the fourth quadrant, on the other hand, we often see that risk does not correlate with opportunity. An example is investing in individual China companies versus investing in a China ETF:
While we can win a lot on Alibaba, we can also lose everything. On the other hand, with a China ETF, we may not win quite as much, but we disproportionately reduce the risk. But why do I say that the risk is different for an ETF investment than for an investment in Alibaba?
Well, it’s because I’m operating in a different quadrant here.
I don’t understand the details (why or which company is subject to possible business-damaging regulations), but that the Chinese economy will continue to exist successfully as such is a relatively reasonable presumption (and this brings us into the realm of knowledge), which puts us somewhere in quadrants 2 and 3.
Graphically, it looks like this:
According to this thinking, I sold most of my China companies (except Ping An) and shifted capital massively into an Emerging Market ETF.
Conclusion
The quadrants of knowledge are a helpful tool for risk management. They show us that we never operate in a world where we understand everything and where we are aware of everything.
This also means that we will always encounter an element that we either do not understand or are unaware of.
Accordingly, I adjust my investments and curb my risk appetite. Because good risk management is like falling into a black hole where you can say: “Well, that’s not unexpected.”
