Key takeaways:

• In avoiding uncertainty, there may be opportunity cost exiting the market at an inconvenient time, or overlooking potential investment opportunities

• Investors may seek to improve their judgement skills with a mindset that acknowledges the fact we don't always get it right, and that we may need to adjust our assumptions or beliefs

• Value investing is a popular investment strategy that aims to leverage uncertainty to identify mispriced' investment opportunities

In almost every aspect of our lives, uncertainty is an area we seek to mitigate or avoid. Quite often, uncertainty prompts a response where we assume the worst, even though it may be a particularly unlikely outcome.

When we extend this to the stock market, it goes some way towards explaining why at the first sign of uncertainty, investors tend to head for the exits in an effort to avoid potential risks and protect capital. 

However, this approach, which effectively strives to avoid uncertainty altogether, also raises questions when it comes to opportunity costs. Let take a closer look.

When History Guides Forecasts

If recent history is any indicator, none of us will need any reminder as to the nature with which uncertainty can sweep over the stock market. From bank collapses, to a tech bust', and of course the pandemic.

The nature of these events also sheds light on the fact that forecasts are just that. As much as we may like to think what lies ahead - and this includes the experts too - the reality is that assumptions play a big part in our expectations, while uncertainty can change all that in an instant. 

Without any rules or science to drive accurate forecasts, we tend to draw on history as the means to help us guide our predictions because this is the only source of knowledge we have at hand. Yet we're all familiar with the notion that past performance is no indicator of future performance. 

And to the point of using history as a guide, it largely ignores the multitude of variables that apply during scenarios where there are a large number of unknowns to account for.

For investors, what this means is that known outcomes or events are not going to drive outperformance relative to the broader market. Instead, it is about responding to, or capitalising upon moments where uncertainty rules the roost.

Where Risk and Uncertainty Diverge

Many investors hear the words risk' and uncertainty' and assume the two share the same meaning. Uncertainty may bring about risk, and risk may lead to uncertainty, but it is crucial these two concepts are separated.

For starters, risk refers to the probability of an undesirable outcome. For investors, this is most commonly understood to refer to a permanent loss of capital. 

On the other hand, uncertainty is the state of something being uncertain, or unknown, yet it can lead to a positive outcome. After all, the stock market is centred on some degree of uncertainty, because there are no guarantees one will make money. Nonetheless, uncertainty in the stock market gives rise to the possibility that investors may be able to generate higher returns than other asset classes. 

Where the two terms do come together, however, is that different investors may have different tolerances for risk and uncertainty. Those with long-term investment horizons may have greater appetite for risk and uncertainty, whereas investors nearing retirement are more likely to prefer less risk and greater certainty.

How Uncertainty May Be Beneficial for Investors

In order to make the most of uncertainty, investors really need to harness the territory that comes with it. Our entry position in a stock might be too early'. We may have bought into a rally too late'. Alternatively, our investment thesis could be fundamentally flawed. From a starting point, investors should understand and accept the fact that we may get it wrong from time to time.

With this mindset, investors can respond to an evolving situation as it unfolds. Knowing that we may have an imperfect set of information, the ability to put aside some of our biases, and revalidating due diligence are vital steps that an investor can take to mitigate their risk exposure whilst trying to capitalise on uncertainty.

Certainty, and even the perception of certainty, are something the market tends to reward with a premium', even if the fundamentals tell a different story. 

But one thing that investors should keep in mind is that while uncertainty typically manifests as risk to investors, including periods of market volatility, these conditions often set the scene for potential investment opportunities. As such, intolerance for uncertainty can lead to opportunity cost.

The key for investors is to develop a framework allowing one to deal with unknowns while looking for investments in a highly volatile environment. Crucially, investors need to be able to distinguish what is an appropriate level of uncertainty. Again, this will differ based on your investment objectives, investment horizon, and tolerances. 

Value investing is one of the more popular strategies to identify investment opportunities in high-quality companies that may arise from uncertainty, with a company fundamental qualities and valuation taking precedence over momentary shocks driven either externally or internally. 

Some of the most successful investors of all time have leveraged uncertainty to drive portfolio returns over the long-term, which suggests it has the potential to be beneficial for some investors. 

SelfWealth Ltd ACN 52 154 324 428 (Selfwealth) (Australian Financial Services Licence Number 421789). The information contained on this website is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser. Taxation, legal and other matters referred to on this website are of a general nature only and should not be relied upon in place of appropriate professional advice.