Risk and Uncertainty

I have been reading about risk and uncertainty in my hotel room in the US even as more than 30 tornadoes lash out in and around the central part of the US. The Weather Channel has been playing on and off throughout the day on my idiot box. Now yesterday, there was uncertainty around the exact location of these twisters which is now gone as the images of collateral damage and the swirling debris comes out from the north east of Oklahoma City. From the perspective of the residents of this area, there was (and actually still is even as I type) a risk of serious injury to life and limb. As the messages on the Weather Channel keep on advising, that risk can be minimised by heading down to the lowest level of your house (preferably a brick/stone/concrete structure and keeping one’s curious eyes away from the glass windows. That is risk and uncertainty. Well, almost!

The major difference between risk and uncertainty is that uncertainty is the lack of faith in a situation while risk is to put yourself in that uncertain situation. Risk can be measured and therefore probabilities can be calculated. With finite probabilities in place, strategies can be devised to minimize them – in the world of investing these would be hedging, collateral posting, diversification etc. When airplanes were introduced, people would have been scared to fly due to the risk involved and they surely must have been right. However, with technological advances that risk has greatly come down. Initially, when the first automobiles ran the streets of London, the Locomotive Act of 1865 sought to control the severe risks of running the iron horse carriages on the streets:

1. Speed limit of 4 mph on country roads and 2 mph on city roads!
2. Each beast must have a crew of three – the driver, the stoker and the red flag man.
3. The red flag man should carry the pennant and walk 60 yards ahead of the vehicle warning people to get out of its way.

So there was risk and it was being minimized. Further, as the harnessing of steam became more efficient, the risk reduced and the law changed accordingly: in 1878 via the Highway and Locomotive Act which reduced the offset of the red flag man to 20 yards. Obviously, the railway and horse carriage lobbies were at play but their arguments must have been eventually blunted by the fledgling auto industry’s demonstration of risk control. Finally, in 1896, the new Locomotives on Highways Act made the following allowances to vehicles less than 3 tons in weight:

1. speed limit of 14 mph
2. no need to have the three member crew including the need to have the red flag man announce the arrival of the vehicle.

Finally, in 1903, the speed limits were further increased to 20 mph and then the law was eventually repealed.

To measure and thereafter control risk, the presence of historical data is required to assign probabilities to various outcomes and construct a probability distribution of the known outcomes. Uncertainty exists when the decision maker has no historical basis from which to develop a probability distribution and must make intelligent guesses to develop a subjective assessment of outcomes and their likelihood. So many folks confuse risk and uncertainty and use them interchangeably. Let me take a topical example to bring out an example of how most people confuse the two terms. Let’s say an insurance company might be willing to take on a certain amount of tornado risk in Oklahoma state. That company might price that risk based on 100 years of past data studying the number, severity, duration, locus, clustering (of tornadoes) and collateral damage. But will the insurer write policies with such large nominal amounts so as to bankrupt the company if any or all of these parameters were exceeded (i.e. on the worse side)? That would be a case of ignoring uncertainty – i.e. the future may not look like the past. Another example from further west of Oklahoma: from the perspective of the individual gambler, betting on activities like roulette or blackjack involve finite probabilities and therefore one can say that playing in Vegas is risky. From the perspective of the house though, while there may be data dating right from the ’30s, they always operate under uncertainty. What if someone comes along and breaks the house? Which is why The Strip strips away a slice of chance from their games (the ‘house advantage’) and keeps itself in the game. Now leaving the events of the Sin City in the Sin City, let me turn my thoughts to how retail rats view investing in equities. There is a whole lot of historical data, no doubt but can exact probabilities be assigned to future stock prices? Subjective assessments are done via various models. Investing is about uncertainty, not risk. Gambling is about risk, not uncertainty. Do you gamble or do you invest? 😉