Known unknowns

Known unknowns are elements of risk or uncertainty that an individual or organization is aware of but whose specific impact, likelihood, or timing cannot be precisely quantified or predicted. In the realm of [Risk management], these are risks that have been identified, but their characteristics remain ill-defined. They contrast with "known knowns," which are facts or certainties, and "unknown unknowns," which are entirely unforeseen risks. [Known unknowns] necessitate a proactive approach to [contingency planning] and preparedness, as their existence is acknowledged, even if their exact nature is unclear.

History and Origin

The phrase "known unknowns" gained widespread public prominence through a statement made by then-U.S. Secretary of Defense Donald Rumsfeld during a press briefing on February 12, 2002. Responding to a question about the lack of evidence linking Iraq to weapons of mass destruction, Rumsfeld famously articulated: "As we know, 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." W¹², ¹³hile Rumsfeld's delivery brought the phrase into popular lexicon, the underlying concepts of categorizing knowledge and uncertainty have roots in philosophy and were used in fields like project management and intelligence analysis prior to his statement.

Key Takeaways

• Known unknowns represent identifiable risks where the specific details of their impact or occurrence are unclear.
• They require proactive strategies like scenario planning and building resilience rather than precise mitigation.
• The concept highlights the importance of acknowledging limitations in foresight, even when a risk category is recognized.
• Managing known unknowns is a critical aspect of effective [risk management] and strategic [decision-making].
• While their existence is acknowledged, the inability to precisely quantify them differentiates them from fully understood risks.

Interpreting the Known unknowns

Interpreting known unknowns involves understanding that while a type of risk is identified, its exact manifestation or consequences are uncertain. For instance, a company might know that new regulations are coming ([known known]), but the precise impact of those regulations on their business model, revenue, or competitive landscape might be a [known unknown]. Similarly, an investor knows that market corrections happen ([known known]), but the timing, severity, and specific triggers of the next correction are known unknowns. Effective interpretation involves qualitative [scenario analysis] to explore potential outcomes and inform strategic [risk assessment] rather than relying solely on quantitative models that might require precise inputs. The Federal Reserve, for example, frequently discusses economic [uncertainty], acknowledging factors that could influence the economy without having perfect foresight into their exact effects.

⁷, ⁸, ⁹, ¹⁰, ¹¹## Hypothetical Example

Consider a large investment firm managing diverse portfolios. As part of their [financial planning] process, they recognize that a potential shift in global interest rates, driven by inflationary pressures, is a significant known unknown. They know that central banks might raise rates, but the exact timing, magnitude, and the cumulative effect on bond prices and equity valuations are uncertain.

Here's how they might approach this known unknown:

1. Identification: The firm acknowledges the risk of rising interest rates. This is not an "unknown unknown" because they are aware of the potential for rate hikes.
2. Scenario Planning: Instead of predicting a specific rate hike schedule, they develop multiple scenarios:
   • Scenario A (Gradual Hike): Rates rise slowly over two years, with minor impacts on long-term bonds.
   • Scenario B (Aggressive Hike): Rapid rate increases leading to significant bond market corrections and some equity sector rotation.
   • Scenario C (Delayed Hike): Rates remain low longer than expected, then rise sharply, catching some off guard.
3. Portfolio Adjustment: Based on these scenarios, the firm adjusts its [investment strategy]. For example, they might reduce overweighting in highly interest-rate-sensitive sectors, increase allocations to shorter-duration bonds, or hedge currency exposures without committing to a single definitive forecast.
4. Monitoring: They continuously monitor economic indicators, central bank communications, and inflation data, prepared to adjust their portfolio further as more information about the "known unknown" becomes clear. This adaptive approach helps them make informed [decision-making] without paralyzing them with uncertainty.

Practical Applications

Known unknowns are a fundamental consideration across various financial disciplines:

• Investment Management: Portfolio managers confront known unknowns such as geopolitical instability, upcoming regulatory changes, or technological disruption. While the existence of these factors is known, their precise impact on specific assets or markets is uncertain. They inform [portfolio management] strategies by prompting diversification, hedging, or maintaining liquidity.
• Corporate Finance: Businesses deal with known unknowns like potential supply chain disruptions from unforeseen events, shifts in consumer preferences, or the outcome of ongoing trade negotiations. These uncertainties influence capital expenditure decisions, debt structuring, and strategic investments.
• Risk Management Frameworks: Financial institutions use the concept to distinguish between quantifiable risks (e.g., credit risk, market risk with historical data) and risks whose parameters are less defined (e.g., the exact nature of the next [event risk]). International bodies like the International Monetary Fund (IMF) frequently discuss systemic risks, which often contain elements of known unknowns, in their assessments of global financial stability.
  *⁵, ⁶ Regulatory Compliance: New regulations are often announced with broad outlines, but the specific requirements, implementation challenges, and enforcement nuances can be known unknowns until further guidance is issued.

Limitations and Criticisms

While acknowledging known unknowns is crucial for robust [risk management], the concept itself has limitations and faces criticism:

• Risk of Inaction: Over-reliance on the "known unknown" label can sometimes be a rationalization for insufficient [risk assessment] or a failure to gather more information. If a known unknown is treated as inherently unquantifiable, it might prevent deeper analysis that could actually convert it into a "known known" with more precise parameters.
• Underestimation of Impact: Even if a risk category is known, its potential severity can be significantly underestimated. This can lead to inadequate [contingency planning] or a false sense of security. Human [behavioral biases], such as optimism bias or overconfidence in one's ability to navigate uncertainty, can contribute to this underestimation.
  *⁴ Blurred Lines with Unknown Unknowns: In practice, the distinction between a complex "known unknown" and an unforeseen "unknown unknown" can become blurred. An event initially categorized as a known unknown might reveal entirely new, unanticipated dimensions, effectively shifting it into the realm of the unknown unknown. The challenge lies in determining how much effort should be expended to convert a known unknown into a better-understood risk versus accepting its inherent [probability] and focusing on resilience. As noted in the Harvard Business Review, managing decisions in a world with unknown unknowns requires adaptive strategies rather than attempting to predict the unpredictable.

¹, ², ³## Known unknowns vs. Unknown unknowns

The primary distinction between "known unknowns" and "unknown unknowns" lies in the awareness of the risk's existence.

While both pose challenges, known unknowns allow for some level of preparation and strategic response because their general nature is understood. [Unknown unknowns], by contrast, are genuine surprises that demand agile response mechanisms, as they could not have been foreseen or planned for. The ability to differentiate between these categories is vital for effective [risk management].

FAQs

What is an example of a known unknown in finance?

A common example of a known unknown in finance is the timing and exact impact of the next economic recession. We know recessions occur periodically ([known known]), but the precise start date, depth, duration, and how different sectors will be affected are uncertain. [Market volatility] is another such example; its existence is certain, but the specific triggers and magnitude of future price swings are not.

How do businesses prepare for known unknowns?

Businesses prepare for known unknowns through [contingency planning], stress testing, and developing adaptable strategies. They might create multiple scenarios, build financial buffers, diversify their operations, and engage in continuous [due diligence] and monitoring to gather more information and refine their understanding as events unfold. The goal is to build resilience rather than predict the unpredictable.

Is a known unknown the same as a risk?

A known unknown is a type of risk. Specifically, it's a risk that has been identified, but its characteristics—such as its precise likelihood, timing, or impact—are not fully quantifiable or understood. All known unknowns are risks, but not all risks are known unknowns; some risks are "known knowns" (quantifiable and well-understood).

Why are known unknowns important in [investment strategy]?

Known unknowns are critical in [investment strategy] because they highlight the limits of traditional forecasting and modeling. Instead of relying solely on precise predictions, investors must incorporate flexibility and robustness into their portfolios. This might involve diversification, hedging, maintaining liquidity, and focusing on companies with strong balance sheets that can withstand various uncertain outcomes. Understanding known unknowns helps set realistic [expectation] for investment performance in an uncertain world.