Unknown unknowns

September 19, 2011 in Data,Risk

I've been observing an interesting phenomenon here in Tel Aviv: people who lie about their cars. I'm not talking about lying in conversation; I mean physically altering their vehicles to make them appear to be other (generally more expensive) cars. The practice is known as "rebadging", since it involves manipulating the model numbers typically found on the back of a vehicle. This is hardly a behavior unique to Tel Aviv -- I noted it regularly in New York -- but I think that because I drive regularly here, I'm more attuned to driving behavior.

Anyway, I was motivated to write this after seeing two different examples on a single drive: an E39 BMW 5 series rebadged as an M5 and a Mercedes SL 500 rebadged as an SL55 AMG. Both cars were masquerading as their "racing spec" big brothers. To someone passionate about cars like myself, the lie was obvious.

In both cases, the badge was simply wrong: the M5 badge was on the left side of the car (it should be on the right) and, more obviously, the owner left the other badge on the car. In other words, the car proclaimed that it was simultaneously an M5 and a 530i.

The SL's lie was more subtle -- the letters "AMG" had been added to the right side of the car, as Mercedes does with their true racing models, and the original badge was left on the left. However, on its AMG models Mercedes removes the last digit of the identifier -- instead of an SL500, there is an SL55 AMG.

Anyway, what I really started wondering was, "What's the point!?" This type of rebadging targets an extremely narrow audience: people who know enough about cars to be impressed by an M or AMG badge, but not so much that they would see through the ruse. That's a very slim intersection on which to focus, especially since with very little effort the lie could be made so much stronger (just get rid of the other badge!), leaving only cues like the number of exhausts to the true nature of the cars.

In other words, people who know a bit about cars will see that this driver is lying; everyone else won't even care in the first place. So why bother?

It made me think of Donald Rumsfeld's famous quote, which I like very much as a characterization of knowledge:

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.

Cars are an excellent domain for studying the implications of these characterizations. Even someone with basic knowledge can recite what they know: at the least, some idea of the basic interaction between the gas pedal and the steering wheel, or just the fact that gas is required to travel. And those same people can quickly volunteer the things they don't know, even if the information is readily available: how the engine works; how many gallons the tank holds; what is "horsepower", exactly? Finally, there are things we don't know and it would never even occur to us to find out (these vary more strongly with experience): how far can you drive on empty? What is unique about a BMW's C-pillar?

Back to the point, sloppily rebadging a car indicates a few things. First, the fact that there are different tiers of cars is one of the owner's known knowns, and he (or she) presumes that is also true of other drivers. However, he must also believe that other drivers don't know how to tell those cars apart except to look for an explicit declaration (that is their known unknown).

The problem is that the owner himself must have a giant unknown unknown regarding other distinguishing features of those cars. So he didn't set out to target those few individuals who respect nice cars but haven't bothered to learn much about them -- he's one of those people himself!

And, because I know my audience, I known I need to tie this back to finance. Fortunately, that's pretty easy. Assume that everything is an unknown unknown.

More specifically, everything you think you know is irrelevant because the market already knows it.

Everything you know you don't know is incredibly important -- how can you possibly make an investment when you're aware that you don't have all the information about it?

And everything else is impossible to find out because you wouldn't know where to start.

The investing game is all about minimizing the things that could remain in your unknown unknowns -- even if you can't know what they are. That's why the "information advantage" of a trader at a large bank (rogue or otherwise) is so critical, and that's why every article that tells you "how to pick stocks!" is ludicrous. The exploration of an investment idea -- turning it around, looking at it in different light -- illuminates facets you would never have seen otherwise.

If you go in with a checklist, you'll never reduce the unknown unknowns: the idiosyncratic risks, the ones you get paid to hold.

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