Risk vs. Uncertainty

Risk is one of those words we use everyday without usually stopping to be precise about what we mean. The term risk is used in different ways. In 1921, economist Frank Knight published his landmark, if under-appreciated, Risk, Uncertainty and Profit. In this book, Knight distinguishes between risk and uncertainty. He defines risk as the calculable statistical probabilities inherent in a situation in which the possible outcomes, and their probabilities, are known or knowable. Under this understanding of risk, in order for a situation to be subject to risk analysis, its set of possible outcomes must be knowable, along with the probabilities associated with those outcomes. For example, betting on roulette is properly subject to risk analysis, because the possible outcomes and their probabilities can be known statistically. The same is true of betting on football, although the estimates of the probabilities involved will be less precise than those involving roulette or other casino games. Uncertainty, in contrast, is the situation in which we find ourselves most of the time. We simply don’t know all the possible outcomes. Because we don’t know all the possible outcomes, we cannot calculate their probabilities, nor can we calculate accurate expected values. For example, suppose you were in Germany in 1900 investing a portfolio. Even if you had considered the possibility of war into your plans, it is exceedingly unlikely, or impossible, for you to have considered even the possibility of events like WWI, poison gas, blockade starvation, trench warfare, the Spanish Flu, the hyperinflation, or aerial bombing. Yet all of these transpired, with widespread fatal (not to mention investment) effects. God only knows what “unknown unknowns” in Donald Rumsfeld’s brilliant phrase, await us over the next quarter century, half century, or three-quarters of a century. At a press conference in 2002, Rumsfeld observed “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. And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult ones.” Some people who disliked Rumsfeld ridiculed the statement. But it is profound, and often overlooked. The concept of “unknown unknowns” needs to be included in any forward looking risk assessment. And that’s precisely the point of uncertainty. We don’t know, we can’t know, even of the potential for many events, and yet many of those events that we don’t even know are possible, will occur.