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.
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, as standing in the quadrant of the unknown-unknowns is like falling into a black hole.
But as so often in life, preparation is key and with the proper skill set, we can handle even the fall into that black hole.
The quadrants of knowledge
The concept of quadrants of knowledge allegedly goes 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 a bit deeper.
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 these two elements. One is the element of understanding and the other is the element of awareness. Based on these four elements, the following combinations/quadrants are possible:
|Things we are aware of and understand
|Things we are aware of but don’t understand
|Things we understand but are not aware of
|Things we are neither aware of nor understand
Let’s take a closer look at the individual quadrants:
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, and when something does happen, the volatilities are not too great. Fat tails do not exist. So we’re talking foot sizes, body sizes, the current weather, time of day, or the age of trees :).
In this quadrant, the return for investors is virtually zero. Why? Return is always the flip side of risk. I lend you money and since I don’t know with one hundred percent certainty whether you will pay me back as agreed, I get a small premium, which we call interest. The return compensates me for the risk that results from this uncertainty.
In a world where this uncertainty does not exist, it is evident whether I will get my money back or not. Apart from inflation compensation, I could not enforce a risk premium.
I know that the comparison is somewhat skewed, but it is intended to illustrate how unrealistic it is for us to earn money with investments in a known-knowns quadrant.
A further implication of this observation is that there is no guaranteed return because such a guaranteed return would be part of this quadrant since its arrival is inevitable and known, i.e., guaranteed. It would, therefore, be a paradox if there were a return as a risk premium in a world that knows no risks.
Accordingly, all internet and WhatsApp group offers claiming to provide me with a sure-fire plan and safe returns are dubious.
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 vulnerabilities.
Donald Rumsfeld did not mention this third quadrant. Nevertheless, it is essential 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.
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 of knowledge 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 confidently say that it will probably never reach a height of more than 2.20 meters. In a desert, we can confidently say 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 we do not understand or are not aware of are subject to a high degree of uncertainty. Politicians or managers should 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 unaware 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 unique 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.
As shown above, It should be clear to any investor that they are not in the first quadrant when investing. 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 – at least not to the same degree, investments in the entire Chinese market via an ETF), as I will show below.
The quadrants of knowledge and risk avoidance
The quadrants are particularly useful for risk avoidance. As my readers know, risk avoidance is critical to 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 flow from it.
Risk management in the third quadrant
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.
So, most of the time, I’m in the third quadrant, where I come across things I’m not aware of but would understand as soon as they reveal themselves (bad quarterly results, account scandals, etc.).
Here, we can actively search and dig to become “aware” of specific issues (that we were not originally aware of). For example, backtesting and looking for unfavorable results (“negative results” means finding results with harmful effects) can bring to light manager promises not kept in the past.
Risk management in the fourth quadrant
In the fourth quadrant, on the other hand, we often see that risk does not correlate with opportunity. An example is investing in individual Chinese companies versus investing in a China or Emerging Market ETF.
While we can win a lot on Alibaba, we can also lose everything. We don’t understand why the government and its regulations behave the way they do. Furthermore, we have no idea what the next steps are regarding the regulation of individual companies.
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 an investment in Alibaba?
Well, it’s because I’m operating in a different quadrant here. If I wanted to invest capital in individual companies, I would always struggle to understand the details (why or which company is subject to possible business-damaging regulations). However, that the Chinese economy will continue to exist successfully as such is still an – at least relatively – reasonable and not too bold presumption (which brings us into the realm of knowledge). In this regard, we are operating in the second or third quadrant.
It looks like this:
|Investment in Alibaba
(Risk lies in quadrant 4)
|Investment in China/Emerging Market ETF
(Risk lies in quadrants 2 + 3)
According to this thinking, I sold all of my China companies and shifted capital massively into an Emerging Market ETF.
The fourth quadrant is everywhere unless we accept its existence
Finally, I throw everything I have said above out the window. The China / Emerging Market ETF example shows that I am making an assumption (the economy as a whole will prosper in the long term) that could later turn out to be wrong. Just because I think I’m operating in quadrants 2 and 3 doesn’t mean that I don’t have one foot in quadrant 4.
The fourth quadrant is like a black swan. I am only surprised by it when I am lulled into a false sense of security. While events such as a pandemic in a globalized world with a huge transfer of people and goods or a meltdown in a nuclear power plant in the course of a war with conventional weapons are only a matter of time, many people consider such events to be black swans.
We must therefore accept that we are constantly wrong. People have to decide for themselves what conclusions they draw from this. For my part, I try to change what I can with the means at my disposal and spread my wealth management across many pillars.
A little side hustle here and a little extra income there completes the overall picture. I therefore don’t have to worry if my China exposure develops to my disadvantage.
The risk associated with the fourth quadrant is, therefore, manageable. I am aware of the risk and, thus, automatically leave the fourth quadrant. And as far as the meltdown of a nuclear power plant is concerned… well, then we have completely different problems. And I can’t diversify away all the risks :).
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 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, and to whatever awaits you there, you could easily and without lying say, “Well, that’s not unexpected.”