Knightian Uncertainty

QUOTE

Margaret Drabble once said…

“When nothing is sure, everything is possible.”

(English biographer and novelist)

CONCEPT

Knightian Uncertainty

Knightian Uncertainty claims that risk can be quantified—outcomes carry known or estimable probabilities—while uncertainty is fundamentally unmeasurable, involving unknown or unknowable probabilities.

Unlike normal, calculable risks (such as rolling dice or forecasting well-understood market fluctuations), Knightian Uncertainty appears in situations where past data provide little guidance for the future, making it impossible to precisely calculate odds or prepare reliable contingency plans.

This concept highlights the inherent limits of prediction and the need for flexibility and judgment in decision-making when faced with the truly unknown.

STORY

The Past … is Not the Future?

In 1998, the hedge fund Long-Term Capital Management (LTCM) found itself at the center of a financial firestorm that illustrated Knightian Uncertainty on a grand scale.

Founded by Nobel Prize-winning economists and led by top Wall Street traders, LTCM used sophisticated models to bet on tiny discrepancies in global bond prices. Their calculations were grounded in historical data and statistical risk assessments—approaches that had garnered the fund enormous profits and widespread admiration.

However, that summer, Russia unexpectedly defaulted on its sovereign debt, sending shockwaves through international markets in ways LTCM’s models hadn’t accounted for.

The hedge fund had assumed a certain range of outcomes based on historical precedents, but the Russian crisis introduced volatility and global investor panic on a scale they had neither witnessed nor computed.

As major players worldwide scrambled for safe havens, LTCM’s highly leveraged positions began hemorrhaging value.

The firm’s meltdown occurred not because they misunderstood measurable risks, but rather because they encountered an unanticipated scenario—something outside their probability bounds altogether. The unstoppable chain reaction forced the U.S. Federal Reserve to intervene and coordinate a multi-billion-dollar bailout to prevent further collapse.

This remarkable case demonstrates that even the most sophisticated data-driven models, built on decades of historical data, can fail when confronted with truly unprecedented events.

LTCM’s downfall has since served as a cautionary tale in the world of finance. It reminds investors, economists, and policymakers alike that sophisticated calculations can help manage or hedge certain types of risk, but when it comes to events beyond our experience or imagination, no formula can accurately quantify the unknown.