Risk vs. Uncertainty

Risk vs. Uncertainty

Risk vs. Uncertainty

All investors consider return. Most investors consider risk. Only a few consider uncertainty.

Those last two statements may seem to many to be synonymous, and in fact for decades have been treated as such by the financial world at large - taking risk and uncertainty to mean basically the same thing. Yet there is a difference between the two which, whilst sometimes difficult to articulate, is as essential to investing as the difference between an equity and a bond.

The first academic work published of the distinction between risk and uncertainty was by University of Chicago economist Frank Knight in 1921:

"Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character…”

Although this description gets to the heart of the matter, an explanation with examples might help to clear things up.

Risk – we don’t know what will happen in the future, but we have a reasonable idea of the possible outcomes. The easy example here is forecasting the outcome of rolling a die.

Uncertainty – we don’t know what will happen in the future, and we have no idea even of the number or kind of options available, let alone a concept of what the probabilities might be. As an example here, think about forecasting what colour an unseen die is.

In the first case, you can calculate the probabilities in your head – there are six numbers, each with an equal chance of appearing. In the second case, it is difficult to even think of the main variable, namely how many colours are there in existence?!

The key point is the difference between something being unknown and being unknowable. If we look at one of the most famous children’s stories ever written, we see a less numerical illustration of this difference. In J.R.R Tolkein’s The Hobbit, Bilbo Baggins wins a magic ring off the creature Gollum by winning a riddle contest. However, Bilbo’s winning riddle is “what have I got in my pocket?” Most people reading the book feel a bit discomfited at that point – clearly the question is not a riddle in any sense! The distinction is between the unknown - hinted at with clues - and the unknowable – the contents of a pocket could be anything in the world. Ultimately, had Gollum been able to clearly articulate the breach of the riddle-game rules through a definition of uncertainty, the whole fate of Middle Earth could have been different…

The odd thing is that there is acknowledgement of this in children’s stories and simple human psychology, but it seems to be forgotten when applied to financial theory. Asking a financial forecaster “what’s in my pocket?” and then, based on his reply, only buying that item would not be a sensible investment approach. And yet, when the same forecaster gives his prediction on where the FTSE 100 might be in a year, heads are nodded, notes are taken, and positions bought or sold.

It is not that the forecaster will always be wrong – he or she may be excellent at their job. It is the lack of acknowledgment for uncertainty that is misleading, the implication that financial market outcomes are as predictable as rolling a die, and that sufficient computational power can produce reliable probabilities when this is simply not the case.

So what can we do as investment managers to mitigate against uncertainty? The first step is admitting that it exists. The second step is trickier, because once we’ve conceded that volatility and standard deviation are not exhaustive measures, we have to distinguish between times when we should use them and times when we should not. This can be key place for an investment manager to add value, because analysis of non-quantifiable risks is always, by definition, going to be an area for judgement rather than a formula.
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