Understanding difference between risk and uncertainty in investing - Motilal Oswal
Understanding difference between risk and uncertainty in investing - Motilal Oswal

Understanding difference between risk and uncertainty in investing

Quite often, we use the terms risk and uncertainty interchangeably. Even investors tend to equate risk and uncertainty when it comes to investments. In reality, there is a very significant difference between the two of them. Typically, we make investment decisions under risk and uncertainty, without actually realizing it. Therefore, it is the key to understand the difference between risk and uncertainty in investment along with an example of risk and uncertainty.

 

What do we understand by risk?

Risk can be understood as the potential for loss. Here loss is defined a little more broadly. It is the probability of a bad thing happening or a good thing not happening. For example, if the profits of a company fall in one quarter, that is a business risk for the company. Similarly, if the market is expecting a 20% growth in profits and the profits actually grow by only 10%; that is also a risk. That is the business definition of risk. From the financial markets point of view, risk is what matters since it can be measured; understood and managed. Typically, financial markets classify risk into two categories viz. systematic risk and unsystematic risk. Systematic risk refers to the market level risk that impacts all businesses equally. In stock markets we measure the systematic risk by the Beta of the stock. Then there are unsystematic risks that are specific to a company or a sector. Weak margins, tough competition are all examples of unsystematic risks. So, in a nutshell risk is something that can be measured based on past experience.

 

But, then what exactly is uncertainty?

If uncertainty also looks like risk, it is actually different. As the name suggests, uncertainty is the absence of certainty. Since the event itself is uncertain, the outcomes also become uncertain. Since the outcomes are uncertain, it becomes to define uncertainty or to measure it. Uncertainty, therefore, reflects a situation where you are not sure of the outcomes. For example, we all know that scientifically Maharashtra is earthquake prone. But it is uncertain whether the earthquake will hit the region in the next 3 years of 5 years. Since the event itself is uncertain, despite being possible, it is hard to measure the outcomes. Focus on the use of the word possible with respect to uncertainty. When it comes to risk, we use the word probably because you can assign probabilities to outcomes based on past experience. Having understood the concept, let us look at the key differences between risk and uncertainty.

 

Differences between risk and uncertainty..
The key difference between risk and uncertainty is best captured by this statement that “Risk is measurable uncertainty while uncertainty is immeasurable risk”. What this basically indicates is that risk is a subset of uncertainty. The extreme component of risk that is immeasurable and therefore unquantifiable is what uncertainty is. Now for some key differences between risk and uncertainty:

Uncertainty denotes a situation where the future events are largely unknown. Since the events are unknown, the outcomes are also unknown. Since the outcomes are unknown, it is hard to assign probabilities to the possibility of occurrence. Effectively, this makes it hard to measure and assign a probability to. Risk, on the other hand, refers to a future event which can be known with reasonable degree of certainty. While the actual event is still unknown, you can assign probabilities to the occurrence of various possibilities based on past experience. That is what makes risk measurable and also manageable.

 

The chart above is fairly illustrative of the differences between risk and uncertainty. It best captures the relationship between risk and uncertainty. For example, when the probability of occurrence of an event is certain, then the possibility of failure is low and the managerial control is very high. When the event is uncertain, then the possibility of failure is very high while the managerial control over the event is very low. Managers, for example, have a very low control over a Tsunami hitting their factory near the coast, which normally happens once in 150 years. Risk is in between these two extremes. The beauty of risk is that while there is still uncertainty over the occurrence of an event, these are based on known factors. Therefore, probabilities can be assigned and managerial decisions taken accordingly.

From a business point of view, risk can be controlled. Let us take the case of a portfolio with systematic and unsystematic risk. The unsystematic risk can be managed by diversifying away from stocks and sectors that are going through trouble. Similarly, the systematic risk can be reduced or managed through beta hedging against Nifty futures. But from a business point of view, uncertainty cannot be measured and therefore cannot be managed.

Remember, since you cannot manage or control uncertainty, you normally take insurance against it. That is where the role of insurance comes into uncertainty. There is no insurance against risk but there is insurance against uncertainty!

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