The Knowledge Problem?

“Reality is merely an illusion, albeit a very persistent one.” – Albert Einstein.

I could’ve more predictably started this post with a quote from F.A. Hayek, well known in economics for what is concisely named “the knowledge problem,” which he lays out in his short writing, “The Use of Knowledge in Society.” But what fun is predictability? And, if it’s knowledge-problem quotes you desire, an entire chapter of this There’s No Free Lunch book is dedicated to the subject.

I took more of the “roundabout” path into wealth management (via engineering rather than economics), but – from my non-economist perspective – the knowledge problem can be summarized as follows: it’s impossible to make good decisions without complete information, and NO ONE has complete information because everyone’s circumstances vary so significantly. The POTUS cannot possibly make broad (macro) decisions that are in the best interest of every US citizen at their particular (micro) level. But even making decisions at the local level is not going to be the best thing for every person. There are always tradeoffs. However, the beauty of free markets is that local decisions made with local, specific knowledge can aggregate to good overall outcomes for society.

When I first learned of the knowledge problem (which, I assure you was much later in life than it probably should have been), it screamed “RELATIVITY” to me, and that brings us to today’s quote and Einstein. While Isaac Newton did a relatively (😊) good job explaining motion observed in the world around us, his equations – though extremely impressive for their 1686 origins – weren’t perfect. Einstein introduced his theory of “Special Relativity” in a 1905 paper to help address the shortcomings of Newtonian Mechanics, particularly related to explaining light, including the well-known equation, E=mc2 (if you think about light for a minute, it’s tricky to pin down, so it was a big pain-point of physics: What is it, actually? Does it have mass? Is it a wave or a particle?).

Relative Lives

It’s apparent that people in different circumstances can have different opinions on occurrences in the world around them. However, special relativity furthers this notion to say that people can have unique experiences of the same event. Two people may effectively see two different events from their unique vantage points – and, importantly, it’s not a matter of interpretation. Concisely, this is because time is relative to the observer, and time moves more slowly relative to a moving object (or person) vs. an object (or person) at rest. There are some interesting examples in this article, such as an astronaut flying at high speed on the international space station for about a year aging more slowly than everyone on Earth (albeit very slightly, but it would be drastically different if we could travel near the speed of light) because “spacetime” is affected by movement.

I think relativity is helpful as a) another way to frame the knowledge problem, and b) a way to have greater empathy for other people. Everyone uniquely experiences life, and everyone cannot and should not have the same opinions or beliefs as everyone else (that is not to say anyone should abandon reasonable basis, morality, or ethics in determining their views and beliefs). No person knows everything that another person knows. And once we accept the inevitability of both relativity and the knowledge problem, we can find better solutions to set the stage for human flourishing.

Alts and the Knowledge Advantage

I’ve had countless conversations with colleagues and clients about why I believe in alternative investments so much, and a large part of that has to do with specific information and control. To be fair, we just got discussing how “no two people know the same thing,” but – in public markets – detailed information about stocks, bonds, and funds is readily available to essentially anyone who wants it. In fact, any material information that isn’t publicly available can’t be used to make investment decisions, or it’s illegal (insider trading). Of course, different people can analyze the public information in multiple ways to draw varying conclusions and investment decisions. Still, the playing field is pretty level regarding available “knowledge” for investors.

Instead, what if you were able to act on the knowledge that others do not have and cannot have about a given company? This is how the world of private investing works, and it’s a “knowledge advantage” rather than a problem. Whether buying or lending to private enterprises, deep analysis can be done to understand those businesses at a level that most other people do not (except maybe the company founders) before making an investment decision. A limited number of investors/managers will be made aware of a given deal in the first place (thus, access is essential), and then they get to decide the terms on which they’re willing to participate in that deal based on the “insider” knowledge they acquire via their due diligence process.

After the deal is done, investors routinely work closely with the company and use their specific knowledge to make real-time decisions to help protect their investment. An excellent example of this was during the onset of Covid when private credit and equity managers worked closely with each of their underlying businesses and properties (in the case of real estate managers) to understand the specific impact of the shutdown. They then adjusted deal terms to help the companies/properties survive, often creating more favorable long-term outcomes for investors in the process (e.g., higher interest or rent payments locked in for a longer timeframe). In contrast, public shareholders are essentially outside observers, receiving reports of critical events only after-the-fact.

Stick to Your Plan!

Another fantastic implication of the knowledge problem is that no one knows you like you know you (and like your advisor knows you). If done correctly, your financial plan was created just for you. Thus, what your friend, cousin, or neighbor thinks you ought to be doing is almost always irrelevant because a) they don’t fully understand your situation and b) they’re probably just projecting onto you what they’re doing for themselves (which is hopefully correct for their situation). I’m all for collaboration and idea-sharing, but remember that “good” financial advice is relative.

Hope Notes

In this time of ongoing needless suffering in Ukraine – with energy and natural resources being integral to the conversation – Einstein’s work also comes with an element of hope. His famous equation, E=mc2, implies that energy and matter are transferrable (the same thing but in different forms). And, if we could turn a paperclip into pure energy, it would be about as powerful as the nuclear bomb dropped on Hiroshima. If that’s remotely true, then our ability to harness energy more effectively can change life for future generations in ways we can’t even dream of. There’s an ongoing (sometimes contentious) conversation surrounding fossil fuels vs. obvious renewable energy sources (which I think requires a “both/and” rather than an “either/or” solution for many years to come), but I think we may be missing the forest for the trees relative to the long-game of energy production. We may ultimately need neither fossil fuels nor renewables in their current forms, but that’s where we face an entirely different knowledge problem.

Until next time, this is the end of alt.Blend.

Thanks for reading,

Steve

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About the Author

Steven Tresnan, CAIA®, CFP®

Private Wealth Advisor

Steve is a Certified Financial Planner as well as a Chartered Alternative Investment Analyst®. He is also an Accredited Investment Fiduciary, which helps him offer guidance to clients with fiduciary responsibilities, such as board members of trusts, foundations, and endowments. Steve earned a Bachelor of Science degree in Industrial Engineering from Penn State University.

Steve serves on the board and finance committee of New Music USA – a national nonprofit devoted to the development and appreciation of new music in the U.S. – and volunteers as the Treasurer for Campus Fun & Learn, a child development center on the campus of Rockland Community College in New York. 

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