Risk and Uncertainty

Impact of risk and uncertainty in attitudes and decisions.
General and financial applications


Uncertainty is everywhere in human life as well as in the Universe.
Risk tries to tame uncertainty by adding arithmetic (probabilities)

People are rather risk averse.
They accept risk normally only if it brings above normal benefit prospect.

As risk and uncertainty give painful feelings, they are sometimes denied,
which leads to false certainties (tenets, beliefs, illusions).

Financial markets and financial institutions are dedicated "shops"
where to buy and sell risks and return prospects.

dynamic Uncertainty is life.
Risk adds calcul arithmetic.

Definitions, and impact on decisions

Uncertainty and risk are both, but with differences, the possibility
of
danger damaging events.

Of course, to get the full picture, and limit the hand wringing and tear
spilling, those possibilities have to be compared to those of favorable
events
.

What makes a crucial difference
between risk and uncertainty is
that those odds are:

  • measure Measurable in the case of risk risk.
  • Non measurable in case of fog uncertainty.

For decision decision making, what is crucial is to be conscious of
risks and uncertainties,
and see how they are balanced by prospective
rewards.


But knowing the objective risk is only a factor in "risky" decisions.
Risk attitudes play also a part
, as is the case in
risk aversion.
Such an aversion has its virtues ...unless it becomes excessive and
freezes any decision and move.
As uncertainty is largely unavoidable, better develop a minimum of
uncertainty
tolerance and admit that decision making entails bets
on the future.

Risk and dice probabilities

As life and the world are always moving and evolving dynamical systems
there is no way to reduce uncertainty to zero.
Surprises can always change the picture.

But certain things are not fully uncertain in the sense that some kind
of mathematical "law" can be found. It helps to estimate with enough
precision the frequency and size of some future events. When we are
able to make such measuring, usually through statistics, we can talk
about risk.

In a casino you know the "normal" chances (risk) to win or to lose, but
less the
uncertainty of slipping on the floor and breaking your neck on
the corner of a gambling table.

Risk is usually measured by using probabilities.
More precisely, risk defines at the same time:
  • the probability itself (expected frequency) of a loss
  • the possible size of that loss (monetary amount, if money at stake).
Probabilities are taken from statistics that show the distribution
(= frequency) of past events.
 
History is supposed to tell all !

But, as seen in the related article,
probabilities are two-faced tools.
  • It is dangerous to ignore them
  • but their relevancy has to be fully examined.

Tools for risk management

In the human quest to control risk, risk management tools, leading to
whole industries
were created and developed: insurance, financial
derivatives, safety equipments and counsellings, protection institutions
and businesses...
Not to talk about some parallel voodoo businesses, as caricatures
of risk management, such as money quacks, deceptive cults,
esoterism...
Not to talk either about gambling, a huge industry in which
probabilities are kings.
Caution has to be applied.
Those devices and institutions should be thoroughly understood
before using them
as some might be illusory or even counterproductive.

Uncertainty and scenarios building

Conversely, fog uncertainty is a non measurable risk.

  • It applies to unknown territories and new situations
Here statistics of similar events are unavailable or irrelevant
and probabilities cannot be calculated objectively.


  • It can also be hidden in what seems run of the mill situations  
Here an excessive trust in, and a wrong use of, historical
probalistic tools
make blind to phenomena proper to
dynamical systems, such as evolutions, potential
disruptions and rare events


In such cases, when hard data are lacking and / or probabilities cannot
be
fully trusted, and if some vision of the future is needed anyway to
make
crucial decisions, (yes, life is made of bets, we better accept the
idea)
scenarios and hypotheses have to be made (subjective
probabilities).

Risk, uncertainty and decision making

A matter of trade off and attitudes

Comparing risk (or uncertainty) to potential luck rewards is one of
the bases of
decision making.

Also, as mentioned above, the attitude towards risk intervene here.
Normally, people are risk averse in the sense that:
  • not that they would balk at any risk taking,
This freezing of initiatives would lead to a stagnant, and soon
extinct, society and human species,
  • but that the higher the risk taken,
the higher the benefits should be.

Also, people are usually more  uncertainty averse than risk averse.
But such attitudes are not so clear-cut.
As people
averserepeal hate uncertainty they would often:
  • Either, to feel more comfortable, let their perception be biased
by "false certainties".
  • Or, in the other extreme,
be hostile to any move which prospects are uncertain,
This makes miss opportunities or might even create a
bigger danger,
this is the flaw of the "precautionary
 principle")
.

Those two extreme attitudes are described below

Extreme 1: False certainties

False certainties in matters which are uncertain are beliefs and
illusions.

They
migh
t be based either on a lack of knowledge or attention, or
on a denial of the unknown to avoid the pain or effort of wondering
how to face it.

Here are some examples:
  • To blind neglect completely past statistics
Something called "base rate neglect"
(a past price for example),
  • To be an overconfidence in a single predicted number
That "range estimate aversion" gives an illusion of
certainty
.
  • To be "contaminated" by other sources of pseudo certainty
Such as  individual or collective overconfidence
and wishful thinking
,
  A vast subject in itself!

Extreme 2:
Resistance to change and precautionary principle

Uncertainty aversion can lead people to "resistance to change" and to
the "precautionary principle".


A)
The resistance to change,
also called mental conservatism or
       status quo bias
is an attachment to things as they have
      been until now and the attempt to keep them unchanged,


It is an emotional bias that is more or less ingrained in the human
mind.

This resistance contradicts life, society and nature, which are dynamical
systems to which we need to adapt.
Of course while keeping the independent right not to follow / not to obey
everything (whether traditional or new).


Such worry, resistance, mixed with a belief in continuity, are obviously
quite active
when what the change will bring is perceived as
uncertain
, thus in some degree "menacing".

B) As for the precautionary principle, it is a paradox that is supposed to
     
safety / orecaut protect from ...what we don't know (*) what to protect
     
about, such as entirely new situations, initiatives or discoveries in
      which the balance between good and bad effects can not be known in
      advance.

(*) and will never know if we don't make experiments.

The common sense would be, not to reject new things and researches
just because of aversion towards the unknown, but to do testing, to
take gradual initiatives that bring a full-scale "return of experience",
thus experiment things to evaluate them.

In other words, the initiative principle, should in some respect
override the precautionary principle
to avoid that progress be frozen.

The case of sous finance

Risk shoppers

Financial markets and financial institutions are shops where
risks as well as return prospects can be bought or sold
.

Investors make arbitrage
between expected rewards and risk /
uncertainty.
They tend to ask an additional return for risky investment compared
to those that are considered riskless.


=>
That bonus is called the
risk premium.

Various financial instruments and contracts, such as financial
options and
other "derivatives" allow to transfer risk between players
against payment.


Financial derivatives are two edged tools.
  • They are supposed to make risk buysell tradable
between those who want to hedge and those who accept
to take the risk together with the related gain prospect.
  • But financial derivatives might be hard measure to assess
when the value of the underlying assets is not well known or
grossly overpriced, as was the case in the
subprime crisis.

Whole theories have been developed around risk in financial markets,
with mathematical concepts such as:
(average price fluctuation variations, systematic risk),
(statistical concepts that reflect risk aversion)

Those mathematical models might give a false impression that
financial risk can be fully reduced
to statistical "volatility" and
can be tamed accordingly.

This is neglecting that a fundamental market uncertainty exists.

Markets are complex dynamical systems, subjected to human
reactions
(with their behavioral biases),in which things rarely
repeat themselves
in identical ways.

Reference and further readings

From the Behavioral finance glossary
and more specifically its
risk and uncertainty pages

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M.a.j. / updated : 07 Aug. 2015
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