Risk and Uncertainty

Uncertainty is life.
Risk adds arithmetic.

Definitions, and impact on decisions

Uncertainty and risk are both, but with differences, the possibility
of damaging events.
Of course, to get the full picture, 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 :

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

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

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.

Risk and probabilities

• the probability itself (expected frequency) of a loss

• the possible size of that loss (a monetary amount, when money is 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

Not to talk about parallel businesses, as caricatures of risk management
such as quacks, deception, esoterism...
Not to talk either about gambling, a huge industry in which probabilities
are kings.

Uncertainty and scenarios building

Conversely, 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 hypothesis
have to be made (subjective probabilities).

Risk, uncertainty and decision making

A matter of trade off and attitudes

Comparing risk (or uncertainty) to potential  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,
  

• 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 hate uncertainty they would often:

• Either, to feel more comfortable, let their perception be biased
  

• Or, in the other extreme, be hostile to any move which prospects are uncertain,
  

Extreme 1: False certainties

• To neglect completely past statistics

• To get anchored on irrelevant data

• To be an overconfidence in a single predicted number

• To be "contaminated" by other sources of pseudo certainty

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

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

It is an emotional bias that is more or less ingrained in the human mind.
This resistance is in contradiction with life, society and nature that are dynamical
systems to which we need to adapt. Of course while keeping the right not to follow
/ to obey everything (whether traditional or new).

Such worry, resistance, mixed with a belief in continuity, are obviously particularly
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
      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 hardly 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"return of
experience" and experiment new 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 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  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 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:

• Volatility and beta coefficient (average price variations, systematic risk),,

• Expected utility, risk premium (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