If you have seen investors getting confused between risk and uncertainty then they are not the only ones. Most people are unable to appreciate the difference between risk and uncertainty. When you invest in the markets or in any other asset class, there is an element of risk and also an element of uncertainty. In many ways, you can say that uncertainty is a very extreme form of risk. You can predict risk based on a mathematical formula and set the limits. In case of uncertainty, it is hard to set limits. That is why uncertainty cannot be managed; it can only be insured against.
1. Let us understand risk, first
Risk has a negative connotation and a positive connotation to it. For example, stock markets hate risk and any stock with a higher degree of risk gets a lower P/E valuation. What is the positive connotation of risk? Remember, all your investment decisions are risk-return trade-offs. To earn higher returns, you need to take higher risks. However, higher risk, by itself, does not guarantee you higher returns. How do we define risk? The risk is the potential for loss. Here loss is defined a little more broadly than your monetary loss or the impact on the bottom-line. The risk is the probability of a bad thing happening or a good thing not happening.
If you expect a company to make a profit and it makes a loss then it is a risk. At the same time, if you expect the profit of a company to grow by 20% and it actually grows by only 12%; that is also a risk. That means; the risk is always with reference to expectations. From the financial markets point of view, the risk is that which really matters since it can be measured; understood and managed. Financial markets classify risk into two categories viz. systematic risk and unsystematic risk. Systematic risk or macro risk is the market level risk that impacts all businesses. Systematic risk is measured by the Beta of the stock. Then there are the unsystematic risks that are specific to a company or a sector. Issues that are specific to a company or industry is the unsystematic risk. In this case, as an investor, you can reduce such
risks by diversifying your portfolio away from such stocks.
2. Uncertainty looks like risk, but it is different
Uncertainty is the absence of certainty; now that sounds a little too simplistic! The key issue here is that since the event is uncertain, even the outcomes are uncertain. Thus it is very difficult to define uncertainty or to measure it since you are not sure of the outcomes. A serious illness in the family, an earthquake in your city, a major fire; are all examples of uncertainty. You cannot measure for that and since you cannot measure, you can either quantify or plan for it. Focus on the use of the word possible with respect to uncertainty. Now the basic difference between risk and uncertainty! The risk is probably and uncertainty is possible. When it comes to risk, we use the word probably because you can assign quantitative probabilities to outcomes based on past experience. In case of uncertainty, since outcomes and events are uncertainty, you cannot measure uncertainty.
3. 3 key differences between risk and uncertainty
It is said that risk is measurable uncertainty and uncertainty is the risk that cannot be measured. Anything that can be measured can be managed and anything that cannot be measured obviously cannot be managed. Let us look at 3 points of difference between risk and uncertainty.
• Since uncertainty represents possible but unknown outcomes, it cannot be measured and since it cannot be measured it cannot be managed. Risk refers to a future event where likely outcomes can be predicted with a reasonable degree of certainty. For example, profits can go up by 10%, 20% and 29% in pessimistic, normal and optimistic scenarios respectively. When it comes to risk, you can assign probabilities to the occurrence based on past experience. Since risk is measurable, it is more relevant for financial markets analysis purposes.
• Risk has the additional advantage in the sense that it can be stratified. You can further classify risk into systematic and unsystematic. You can also stratify risk into high risk and low risk. This helps you to better manage risk. If you are an investor or a portfolio manager, then you can manage unsystematic risk by diversifying your portfolio away from the trouble spots. Even systematic risk can be managed by Beta hedging your portfolio.
• The concept of uncertainty is central to insurance. We always insure the uncertainties in life. We insure against loss of life, ill health, fire, riots etc. You cannot assign probabilities to your property getting destroyed by fire or by riots. These are just uncertainties and can only be insured by paying a premium. Risk cannot be insured. Since risk can be managed, insurers are not interested in the same.
Understanding the difference between risk and uncertainty is at the core of investing.
The author is Senior Equity and Research Analyst at Angel Broking. Views expressed are his own