I have made it a habit to talk about risk and uncertainty in many social and academic gatherings over the span of the last two years, when the contemporary and relatively new theories of risk management became areas of great interest to me. But the more I talk, the more I feel the necessity to truly understand the difference between risk and uncertainty. Let’s think of a simple example that I picked from the book Flaw of Averages by one of my favorite writers - Dr Sam L Savage.
We say “beauty is in the eye of the beholder,” proponents of this idiom give the following example: Imagine being in the middle of an inaccessible woods, a very rare and a beautiful flower blooms, and there is no one to see it. Would it still be beautiful? A good topic to debate over, but let’s not deviate. I will give a similar example. Let us consider the same inaccessible woods, where right in the middle there is a tall oak tree, and on the branch of the tree sits a coin, hanging precariously in balance, ready to drop any time. Which of its two sides will be facing up? Either heads or tails. That’s uncertainty - the possible range of things that can happen. But does anyone care? Since it’s inaccessible, we may never know whether it’s heads or tails; and we will also not be much interested as none of our financial and non-financial gains or losses are tied to the outcome.
Now consider this scenario: I have a bet with you that if the facing up side is heads, I get Tk10 from you, and you get the amount from me if it’s tails. Now I would be very interested at the outcome, as I risk losing money if tails comes up and I am compensated for taking this risk with the gaining of money if heads come up.
This example highlights the difference between risk and uncertainty. Uncertainty refers to the possible set of outcomes for any scenario. But if we have nothing to lose in these uncertain outcomes, then this uncertainty does not lead us to be at risk. And this brings us to one very important principle of risk management - the objective is to minimise risk not uncertainty, by a clear understanding of the possible uncertain outcomes. And the latter part of the previous sentence is the hardest thing to achieve.
The identification of all possible outcomes should be the most important exercise for any risk manager, whether that risk be financial or non-financial. As best-selling writer Nicolas Nassim Taleb puts it in his famous book The Black Swan, the biggest challenge is to identify these outcomes, as sometimes we may never know some of the outcomes unless it really takes place, and in which case it will be too late already. And more than any set of fancy calculations, any intricate set of models, detailed software, I believe the first and the most fundamental step of risk management is to take a step back, look at the picture as a whole, and try and identify all the possible (no matter how unlikely) outcomes of any scenario. After all, a calculation or a model based on false assumptions will lead to an unreliable result.
The principle discussed in the last paragraph brings up another very important set of questions: why minimise risk only? Why not uncertainty? Isn’t uncertainty bad as well? Not necessarily. See, uncertainty is just the possible set of outcomes and their probabilities. As in the coin in the tree branch example, if you have nothing to do with these outcomes, then the uncertainty means nothing to you. But what if you have financial or non-financial assets tied to the uncertain outcomes. Even then, uncertainty is not something that is always bad, given that you have taken proper precautions to protect yourself from the possible outcomes.
Let’s take a very simple example: Say you own a piece of land, which may or may not have oil underneath it. You can dig up the land, and then know whether the oil is there or not. Here lies the uncertainty, in the possible presence of oil, and the risk is the cost of digging, which you risk to lose if you do not find oil. But we can do better. We can lease our land to a company, which is in need of oil and can afford to dig for it. Let’s say we lease it for five years. So what are the scenarios now? Either the company finds oil and enjoys the profits for first five years, after which the profits become yours, plus the amount you generated from the yearly lease amount. Or, the company digs and does not find anything, in which case, you do not lose the cost of digging.
In fact, you stand to gain money in the form of lease payment. So, here the uncertainty does not bother you, as you are in a situation that leads to your gains in both possible outcomes. In fact, there can be cases where uncertainty can actually be good, where you can gain from uncertainty. Such is the field of hedging, financial options, real options, and derivatives. A word of caution though, before being blinded by the outcomes these fancy names give you, be wary of understanding all the possible future states and their probabilities. Because only knowledge of future outcomes can help you prepare for the uncertainty, and if possible, take advantage of that uncertainty.
This article was more based on the fundamental side of the real difference between uncertainty and risk. And through this differentiation, we looked into the true essence of risk management - not only to minimise risk, but to understand and identify the possible outcomes that any event can have, and then make proper plans for all these outcomes.