Weekly Insider (Vacuums, Pears & Probability)

Below is a preview of this month’s issue, but first here’s the thing. Nature abhors a vacuum. And people abhor uncertainty. As social creatures: when we don’t know something, we look to others for clues--even if they’re clueless. As pattern-seeking creatures, when we don’t know something, we look to the past and play the childhood game of ‘Memory’. We internally say, “Hey, that market movement looks just like that market movement I saw before.” It’s only slightly more sophisticated than drooling on ourselves as we grab for the card with the “Pear” on it.

The funny thing about looking to others is this: they’re often looking to us. It can quickly become a recursive hall of mirrors. Like a video camera pointed at a TV screen playing what’s on that video camera. And the thing about markets is this: they only function properly when you have buyers and sellers. And for a buyer and seller to meet, they must see two different things. One is buying something from the other because he/she presumably sees something the other doesn’t. (Maybe they have different information or maybe the magnitude or the duration or the probabilities of some event they are both seeing have different weighting). Liquidity exists only when buyers and sellers see different things. They have diverse views. When they see the same thing and act accordingly, there is a diversity breakdown. And then you get bubbles and crashes.

Now, when it comes to pattern recognition, here’s the rub: past isn’t prologue. There’s a reason it’s called “news”. As Kurt Vonnegut once said, “History is merely a list of surprises. It can only prepare us to be surprised yet again.”

Yet risk and uncertainty are the basis for all pricing and discounting the future—and thus pricing and discounting all assets. Aesop’s Fable nailed it in folksy terms: ‘a bird in the hand is worth two in the bush.”

Increasingly the one thing I know for sure is as that might say in my native Brooklyn, nobody knows nuthin’. And the other thing is that payoff is inversely proportional to expectation. The lower the expectations, the higher they payoff if it hits. And the higher the expectations—well, it’s already all priced in.

In John Maynard Keynes’ “Treatise on Probability” he outlined what would later become better known as the Ellsberg Paradox. It goes like this: Let’s say you have a box with 30 red balls and 60 other balls that might be black or yellow. Without knowing how many black or yellow balls are in the box, you know the total of both is 60. The balls get mixes in the box and you are given two choices. Choice 1: you get $1,000 if you pull out a red ball. Choice 2: you get $1,000 if you pull out a black ball. Around the same time, you’re given another set of choices. Choice A: you get $1,000 if you pull a red OR yellow ball. Choice B: you get $1,000 if you pull out a black or yellow ball. So which would you choose?

Well, you’d pick Choice 1 over Choice 2 only if you thought you were more likely to pull a red ball than a black one. If you thought the odds of pulling red or black were the same, you’d be indifferent. Likewise, you’d pick Choice A over Choice B if you thought that pulling a red OR yellow ball was more likely than pulling a black OR yellow ball. If it’s more likely to pull a red one than a black one, then pulling a red OR yellow one is also more likely than a black OR yellow one. So if you picked Choice 1 over Choice 2, you’d also prefer Choice A over Choice B. And if you preferred Choice B to Choice A, you’d then prefer Choice 2 to Choice 1.

But when asked, most people almost always prefer Choice 1 to Choice 2. And Choice B to Choice The reason: most people prefer known risks to unknown risks. This is called “ambiguity aversion”. Also, the more risk-averse someone is the more they’ll pay to get rid of risk, taking a sure $1 over a 50% shot at $3—even though taking the latter is more rational because it’s expected outcome is higher. Some theorists think this explains why one person could buy both an insurance policy and a lottery ticket—which isn’t as irrational as some might suggest. There are all kinds of variety of other games and thought experiments, like the St. Peterburg Paradox, Martingale Progression, Gambler’s Ruin.

Now, here's a controversial question: What if you didn't have to die? When asked this, first my eyes rolled; then my eyebrows rose. This month be sure to read the special three-way interview in our premium Forbes/Wolfe issue with Aubrey de Grey, who will eventually either prove to be off his rocker or prove to have helped you avoid a rocker in the first place. Weighing in with a more conventionally credible scientific point of view is David Sinclair, Harvard rising-star, founder of recently public company Sirtris and venture partner at my firm Lux Capital. While a "cure" for aging might seem far-fetched, and a "cure" for cancer, less so—a lot of smart people (and the smart money backing them) are trying to turn cancer into a treatable condition like diabetes. Nanotech is front and center attacking cancer like a molecular military, replete with covert and timed attacks, Trojan horses that would make Ulysses proud. Also, you read it here first: One of the great frontiers of technology (both hardware and software) is the haptic interfaces and displays that we react to and interact with. The molecules and materials from Apple's iPhone to Cambrios' touch-screen materials to flexible displays are putting the "active" in interactive. This is an area ripe for innovation and change—meaning it’s also ripe for in-the-know investors to position themselves ahead of others. The future, like information, is here—it's just unevenly distributed. As always, here's to thinking big about thinking small...and to the emerging inventors and investors who seek to profit from the unexpected and the unseen....