Longtime readers will recall that I find the Uncertainty meme to be mostly silly (see this and this). The foolishness continues to come up amongst allegedly serious people. I find many of these folks (mostly) devoid of original thought, choosing instead to repeat things pundits of questionable insight have previously said (PoQI™ is a registered trademark of TBP).

I mention this because Michael Mauboussin, who is an orginal thinker with outstanding insight, discussed this very subject not too long ago. On Bloomberg TV, he had broad discussion of skill and luck in sports, business and investing. Almost as an aside, Mauboussin’s made some extremely insightful commentary about “What is Risk,” and how that compares to our peeve, “What is Uncertainty.”

He nailed the distinction in a way I found simply fascinating. Consider the distinctions Mauboussin makes:

Risk: We don’t know what is going to happen next, but we do know what the distribution looks like.

Uncertainty: We don’t know what is going to happen next, and we do not know what the possible distribution looks like.

In other words, his view is that the future is always unknown — but that does not make it “uncertain.” Rather, he takes the analysis a step further, quantifying this in the language of statistical probability.

A statistical approach perfectly clarifies the falsity of the uncertainty meme.

When we don’t know what any future outcome will be, but we understand the probability distribution — think of dice or a multiple choice exam — we have risk, but we do NOT have uncertainty. We never know what the roll of the dice will be, but we do know its one of six choices.

Is that uncertainty? The answer is of course not — it is an unknown outcome with well-defined possibilities. We may not know precisely which outcome will occur in advance, but we do know its either 1, 2,3, 4, 5 or 6. Call that risk or an unknown future, but do not call that uncertainty.

I am pushing against a usage that conflates “Uncertainty” with”Unknown.” Since the future is, by definition, always “unknown,” then what purpose does it serve to say there is Uncertainty? By that definition, there is always uncertainty. As currently heard in the MSM, this renders the word utterly meaningless.

Consider alternatively what is the true definition of Uncertainty: That occurs when we have no idea of what the possible outcome might be. The probability distribution is unknown (or so extremely large as to functionally be the same as unknown).

The so-called fiscal cliff is a perfect example — we know what the possible outcomes are, and we have a very good idea what their impact will be.

Hopefully clarifies the silly meme that seems to conflate “Uncertainty” and “Unknown” as the same things…

Previously:
Kiss Your Assets Goodbye When Certainty Reigns (Bloomberg,  November 9, 2010)

There’s nothing new about uncertainty (Washington Post, July 7 2012)

Mauboussin on ‘The Success Equation’ (November 20th, 2012)

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

42 Responses to “Defining Risk Versus Uncertainty”

1. [...] Defining risk vs uncertainty. [...]

2. [...] this post? When we don’t know what any future outcome will be, but we understand the probability [...]

3. CSF says:

Barry, I appreciate how you’ve been trying to cut through the BS about uncertainty, and Mauboussin hits the nail on the head, as usual. However, I’ve been struggling to understand part of your argument, here. Are you saying that the uncertainty meme is mere rhetoric – a flawed explanation conjured by the media and pundits, meaning that the majority of CEOs are not influenced by such doubts and investors shouldn’t be, either? Because while I’d like to believe this, it runs counter to the ongoing flood of interviews I hear on Tom Keene and other programs. You hear the uncertainty meme not only from the media and analysts but also fund managers, economists, and CEOs. Alternatively, are you arguing that uncertainty is a behavioral meme – people in finance and business are feeling and behaving cautiously because they are following the herd, and they misunderstand the risks and uncertainties? Because while this may be true, it seems possible the uncertainty meme could be a self-fulfilling prophecy, like consumer confidence. Thanks in advance!

4. Jack Damn says:

Excellent. Great explanation.

5. rd says:

We live in an era of “Buzzword Bingo.”

The more au currant buzzwords that I see in a statement, the less attention I pay to it because it is clear that the person burbling is probably out of real ideas.

Uncertainty has become the new corporate euphimism, replacing “innovation” which was the big theme from the past two years. When was the last time that we did not have actual uncertainty, even people thought we didn’t have uncertainty? We live in a sea of risk and uncertainty, although sometimes the waves are bigger than at other times. It is the reason that we were programmed by nature to grab something today in case we don’t have access to it tomorrow (like Wimpy’s hamburger).

6. denim says:

The term “uncertainty” is used by Keynesian deniers. Otherwise, the the fact that lack of aggregate demand causes recessions and unemployment might pop up into the conversation an embarrass them.

7. This is a definitional issue

Since the future is by definition always “unknown,” then the way most people incorrectly use the word there must always be Uncertainty.

That make the use and overuse of the word as currently heard in the MSM utterly meaningless. If there is alwayss uncertainty, how can you blame so much on it this month/quarter/year ?

I like that MM defines it in a way that is useful. I try to avoid mathematical or probabilistic definitions (too many people wont follow it) but I thought this one explained the nuanced distinction between risk that is quantifiable and uncertainty that is unquantifiable.

Most people use “Uncertainty” incorrectly, and the media especially gets it wrong

8. rtalcott says:

I can see being able to determine the likely (and not so likely) outcomes…but NOT realistically (in many cases) coming up with a good guess at the probability distribution…and when I see postulated pdf’s I’m thinking this is more bs.

rt

9. Low Budget Dave says:

Every time that Fox News says “businesses are not willing to create jobs because of all the uncertainty”, I always end up yelling at the television. If entrepreneurs are not willing to face an uncertain future, then why do they get to keep the profit?

Michael Mauboussin was a guest on Consuelo Mack’s Wealth Track yesterday. A replay is available on Wealth Track’s web site:

http://www.wealthtrack.com/

11. This is how Frank Knight distinguished risk and uncertainty in his 1921 book, “Risk Uncertainty and Profit”.

12. Jim67545 says:

As a senior loan officer I live risk. Risk in loans of course has to do with probability of loss, interest rate risk and such. Risk in loans is also dependent on duration. Make a highly risky loan but sell it off in a couple days virtually eliminates risk because it is off portfolio before the first payment is even due. So, (as in prior to the housing bust) one takes risks which one finds acceptable.
But, when the inability to sell the loans off as expected arises, or those to whom they are sold use representations and warrantees or suit to force buyback of these loans or when servicing costs skyrocket, these are unanticipated uncertainties.
Eventually these uncertainties are either mitigated or become understood/quantifiable. At that point they become a new part of “risk.” Until that happens lenders retreat into lending in which these uncertainties appear to be minimal. Hence the meme about “nobody can get a mortgage unless they are golden.”
So the point I am making is that risk and uncertainty are close cousins and one can shift into the other over time. For example, to the extent that an element of risk (decisions pertaining to allocating capital), such as the business accellerated depreciation deduction, becomes uncertain (as to its continuation), businesses will either modify their approach or pull back from making the decision.

13. BITFU Search Engine says:

Risk is active. Risk is tool used to help you decide what to do in the face of a random outcome, BUT with a probable distribution. Yes, the outcome contains uncertainty, but it’s “limited uncertainty”.

Uncertainty–as used in this post , is unlimited uncertainty. What’s more, this kind of uncertainty entails (or should, anyways) passivity…because you don’t have enough information to act. Uncertainty involves a random outcome that cannot be quantified. Rather than being a tool (like Risk), this uncertainty is what happens TO you in a non-deterministic future.

Or, looked at another way: If you have an urn AND you know something of its contents (ie, it only contains white marbles and black marbles) then you are entering the domain where you can employ Risk. If, on the other hand, you have an urn, but you don’t know what it contains (ie marbles, money or mousetraps), then you have uncertainty.

With the first urn, since you have reliable information on its contents you can –with repeated sampling– predict the outcome (distribution(!)) just as confidently as you can predict what will happen if you smash an egg with a hammer. This is Risk.

But, you cannot predict how the particular egg will splatter. This is Uncertainty.

BUT, if you smash enough eggs, you can then begin to predict how eggs will in fact splatter. This is Risk interacting with Uncertainty.

14. jonas says:

I think “risk” turns into “uncertainty” according to the pundits that be, because they deny the possibility of certain outcomes. If you roll a dice, but deny that 6 is a valid number on the dice face, then the outcome of the dice is uncertain. Who knows what happens when a 6? Do they make you re-roll? Do they change the dice? Do they shut down the casino?

Similarly if you deny the possibility of raising taxes in the course of resolving the fiscal cliff, then the risk becomes an uncertainty. Who knows what’ll happen when taxes are raised? It’s rampant uncertainty! Do they re-do the talks? maybe they’ll change the govt…

15. jonas says:

I think “risk” turns into “uncertainty” according to the pundits that be, because they deny the possibility of certain outcomes. If you roll a dice, but deny that 6 is a valid number on the dice face, then the outcome of the dice is uncertain. Who knows what happens when a 6 comes? Do they make you re-roll? Do they change the dice? Do they shut down the casino?

Similarly if you deny the possibility of raising taxes in the course of resolving the fiscal cliff, then the risk becomes an uncertainty. Who knows what’ll happen when taxes are raised? It’s rampant uncertainty! Do they re-do the talks? maybe they’ll change the govt…

16. NoKidding says:

I disagree with all the “great post” responses. Looks to me like you defined uncertainty out of existance, then by that definition called people who believe there is uncertainty fools.

Example of risk: 6-sided dice
Example of uncertainty- vague words

Add an actual real world example of what you would call uncertain. I’m guessing that you’ d either have to adjust your definitions or admit they don’t leave any room for a real life example without wordy conditions.

17. I am not defining it away, I am giving it a definition that gives it clarity and meaning.

Uncertainty is where you do not know what the probability distribution is — think wars, black swans, new viruses, health scourges. Those are uncertain.

Ordinary unknowns are not uncertainty as currently misused, especially in the MSM.

18. whskyjack says:

Are you using a specific technical definition here? Because uncertainty as defined by Merriam -Webster is much more broad than that. And as such is being used correctly. Uncertain is not unknowable as your quote seems to imply. In fact his definition of risk is a defintion of uncertainty. Risk being closely tied to uncertainty as it is the mathematical evaluation of uncertainty. The moment of my death is uncertain and unknowable. But the number of 60 yr old men who will die today is uncertain but measurable with in a range.

Uncertainty= the quality or state of being uncertain.

19. Using the dictionary definition, isn’t the future always unknown and therefor uncertain?

Given that reality, what value is telling us that Uncertainty is causing XYZ ? Isn’t there ALWAYS uncertainty?

You cannot have it both ways.

20. AHodge says:

A heavy subject and a good contribution. Coup-le thots

1 you should be so lucky to get much risk as straight probability distribution

2 many talk like risk/ uncertainty is mostly a bad thing. seems to me there is the upside, in fact for your “risk”distribution its exactly equal.
3 the world is full of wild ass things like crazy arabs etc weather, stuff we have created and dont understand blowing up, like nukes and the financial system. id say more than than half of these are bad for most asset prices. A japanese royal could get ill tomorrow and knock down the yen.
4 unless it a bimodal yes /no like an election, or israel not attackig iran, stuff that is good tends to show up or be seen slowly like our energy revolution
5 you can learn exactly what odds are for any event that is priced with options or bookie odds. like the election next fed hike. doesnt mean it right. but there is your shot to bet against in lifes big casino. make your odds (loved yur earlier coin spinning odds BTW thanks)
in fact as time unrolls there is only one outcome, we just are not capable of knowing it yet

i would not even listen to most of the complete losers bloviating on bad democrats making the minds of businessmen uncertain, except to mark as an intelligence test.

i do think that some of the extreme threats of congress tying itself to the mast
with both sides but i ill say mostly republicans making themselves important and the center of attention ,
with cliff /debt ceiling etc is having an effect.
but thats not uncertainty as much as

if i said its a certainty we are going over the cliff and freezing the debt ceiling, would anyone be reassured?

21. AHodge says:

actually
there are no doubt some including here who would be assured with a debt freeze or cliff..
there is some small probablility they may be right
i would say there is not much more than zero the markets would like it.

22. Matt P. says:

I believe there is an enormous “risk” that by listening to pundits from Legg Mason you will be “certain” to transfer your wealth to their accounts and fund their yachts.

23. osheth says:

Here is how Nate Silver defines it:

Risk, as first articulated by the economist Frank H. Knight in 1921, is something that you can put a price on. Say that you’ll win a poker hand unless your opponent draws to an inside straight: the chances of that happening are exactly 1 chance in 11. This is risk. It is not pleasant when you take a “bad beat” in poker, but at least you know the odds of it and can account for it ahead of time. In the long run, you’ll make a profit from your opponents making desperate draws with insufficient odds.

Uncertainty, on the other hand, is risk that is hard to measure. You might have some vague awareness of the demons lurking out there. You might even be acutely concerned about them. But you have no real idea how many of them there are or when they might strike. Your back-of-the-envelope estimate might be off by a factor of 100 or by a factor of 1,000; there is no good way to know. This is uncertainty. Risk greases the wheels of a free-market economy; uncertainty grinds them to a halt.

24. WaltFrench says:

OK, taking your definitions as given: what economically meaningful risks are there?

We know the probability distribution of the lottery, but that has near-zero macro impact (in part, because we know the risk exactly). We know that only one team will win the World Series. (Big whoop!)

OTOH, we don’t know the probability distribution of any financial instrument … the change in the labor force participation rate next month … the temperature in New York City May 1st, 2018 … Paul Ryan’s likelihood of winning he Republican Party nomination.

In other words, outside of textbook examples of “urns” (charmingly quaint, no?) with 100 red balls and 50 whites ones, we have only very imperfect guesses at the probability distributions. This has been the case since the beginning of time; it was only a few benighted forecasters who claimed to know the probability distributions.

All of which makes the distinction rather moot. Any practitioner who didn’t already grok this was probably making all sorts of other stupid guesses, too.

25. AHodge says:

i will say that most of the academic economists like bernanke
and also not trained economist but highly opinionated greenspan
are complete idiots about risk, and know zero about option markets etc
they thoght the last collapse was completely not to be possibly anticipated “fat tail”
you could look at barrys list of flaws
ray dalios credit cycle peak
and say as he did, “there is a bubble and you know its a bubble”

26. AHodge says:

not that i have anything against slightly fat tails
but using it in the geek way is another intelligence test

27. constantnormal says:

“There are known knowns. These are things we know that we know.
There are known unknowns. That is to say, there are things that we now know we don’t know.
But there are also unknown unknowns. These are things we do not know we don’t know.”

— Donald Rumsfeld

28. Incredulous says:

I’m going to have a crack at this….

A) Uncertainty is what people feel when they entertain doubts. A person, feeling unsure, is uncertain. That seems pretty clear: for people, uncertainty is what Aristotle would call a “passion,” that is, a feeling–not a “characteristic.”

B) A thing that has not been established is, by definition, uncertain. Skeptics believe that everything is uncertain, because nothing can be known or established absolutely. They are pretty sure of this, although Pyrrhonists dutifully go so far as to doubt even their own uncertainty. How does the world turn? Because people behave as if they had real knowledge, and act accordingly.

What the press is describing when it says the market is suffering from uncertainty is A, not B, and the press is right.

A risk is something that people take, whether they feel certain or not. “I’m going to climb that mountain.” “Yeah? Isn’t that risky?” “I’m certain I can do it.” There is no contradiction here. The outcome is uncertain, because it cannot be established, or “ascertained.” The activity is risky. But the person is certain. Almost everyone who feels certain he will succeed, while taking grave risks, is proven horribly wrong. That is due not to “risk” but to “statistical likelihood,” which is based on the conceptualization of many individual chances taken collectively.

Solon said, “Call no man happy until he has died.” Aristotle had problems with that, and I think rightly: certainty occurs in the moment, and is not changed by the way events come out. “I was certain–how could I have been so wrong?”

All it would take is for everyone to make a realistic appraisal of their chances, and most human activity would come to a halt. Would you flip a light on if you knew the switch would shock you badly one in a hundred times? Uncertainty is very real and it is even frankly quantifiable: the amount of money people keep in cash and gold, times sales of guns and ammo, divided by the PE of the S&P, might be a good start for an uncertainty index.

29. Incredulous:

Some time ago, I pointed out the psychology of Uncertainty:

Most of the time, people exist in a happy little bubble of self-created delusion. We engage in selective perception, seeing only the things that agree with us. Our selective retention retains the good stuff and disregards most of the rest. In our minds, we are all younger, better-looking, slimmer, with more hair than the camera reveals.

In short, we construct a reality that bears only passing resemblance to the objective universe.

During those brief instances when the facade fades, the curtain gets pulled back and the ugly reality becomes clear. We get a glimmer of understanding about our own lack of understanding. That’s when the grim reality of the human condition is revealed — and it terrifies us.

When we briefly admit to ourselves how incomplete our understanding of the objective universe is, how little we actually know, that is where Uncertainty rears its head!

30. formerlawyer says:

Risk is an acceptable gamble. Uncertainty is an unacceptable gamble. TIC.

31. [...] Defining risk vs. uncertainty.  (Big Picture) [...]

32. AHodge says:

in the good times we delusionally optimistic
but as you point out in the bad times delusionally pessimistic

as to not knowing shit
of course we dont
get used to it
not all we dont know is bad

they say some people have gone insane studying quantum mechanics
or really contemplating how little they know
thats probably because they had way too hi an opinion
of what their mind could know

33. CANDollar says:

Risk and Uncertainty in Retirement Planning: How to minimize the potential for Bad Outcomes

Uncertainty: I can govern how much I will have in retirement or other future need by saving what I need in the risk free return of TIPs sufficient to generate my floor income, that is the income needed to fund my future expenses

Risk: I can take risk with the rest of my capital in equities and any return in excess of the risk free return is a bonus that increases my standard of living.

The bottom line of this reasoning is that unless one is willing to bet capital such that a bad outcome is possible, one needs to save a lot more that the financial services industry would have us believe.

See: Zvi Bodie – The Escalating Life Annuity

34. RW says:

Uncertainty may not be recognizable in advance or it may be masked by prevalent practice; e.g., you think you know the risk, the distribution you’re using has a track record, but that distribution is historical and not necessarily fundamentally constrained by the nature of the world.

My main take-away from Taleb’s ‘Black Swan’ was its direct challenge to a number of core principals currently in vogue in quantitative finance, particularly those dealing with assumptions of normalcy and calculations of risk.

Black Swan basically states that (most) price changes are not normally distributed; they are more accurately characterized as following a power law.

This implies much greater extremes of price movement than those predicted under the assumption of a normal distribution and also implies that statistics such as standard deviation and correlation are probably misleading; that is, both standard deviation and correlation are defined in terms of variance and since variance can be infinite for stable power distributions (non-normal but Levy skew alpha stable) neither standard deviation nor correlation can actually be defined.

With a normal distribution, a 10 or 11-standard deviation event is pretty rare. Getting several moves twice that size in the same month with an even larger deviation in-between tells you that you are either witnessing an event on the order of The Second Coming&reg or the phenomenon in question is not normally distributed; e.g, GS CFO David Viniar’s comments from August 2007 when the ABS meltdown got into full swing: “We were seeing things that were 25-standard-deviation moves, several days in a row”.

If market prices were distributed normally, the chance of a 25 sigma move is virtually indistinguishable from zero; you might expect to see one sometime between the big bang and the end of the universe, but maybe not.

NB: In a dynamic system a power distribution could be misleading too — more able to capture the chance of explosive change but paralytic in its effect because risk is so huge — and it is quite possible that models with multiple equilibria work better; calculating when the shift to a new equilibrium occurs would probably remain a real challenge but the distribution of each equilibrium surface would be fairly well understood once you were in it.

35. tomkroupa says:

Here’s my take: Uncertainty is the likihood of an event occurring or not occurring. It can be approximated by a probability i.e. with great uncertainty the probability of a particular event happening is very low. Risk is a measure of uncertainty in conjuction with what’s a stake. If you bet a dollar that the stock market will double next year, that’s low risk but high uncertainty. If you bet a million dollars that’s high risk (assuming you’re not a billionaire).

36. Rightline says:

Uncertainty just has a much larger area of probability distribution.

There is a risk we will all die. There is uncertainty when we will all die…

37. DiggidyDan says:

It is all merely semantics, however, I understand your point, and I like your definitions of the terms. If only as a populace (and a world speaking different languages) we could all agree on these concepts.

“Statistical Probability is a Universal Language?” ~A nebulous quasi-quote that seems plausible due to appealing to your inherent beliefs and subconscious memories and thoughts.

38. Fazz says:

Ritholtz – you are right to argue against conflating “uncertainty” with “unknown”; they are not the same thing. However you are wrong to define uncertainty as the situation that occurs “when we have no idea of what the possible outcome might be.”

As alluded to above, the economist Frank Knight wrote about the concept of uncertainty. Knight described the general situation as follows: “It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is true of business as of other spheres of activity. The essence of the situation is action according to opinion, of greater or less foundation and value, neither entire ignorance nor complete and perfect information, but partial knowledge.” (Frank H Knight; Risk, Uncertainty and Profit; 1921; page 199).

The important point to note is that uncertainty is not defined by reference to having “no idea” of what the possible outcome might be (i.e. complete ignorance), but by reference to having “some idea”, albeit insufficient to enable us to precisely specify a unique probability distribution with absolute certainty. In some circumstances we can still guess at what the possible probability distributions might be, in other cases we cannot.

The question we are then faced with is: “How is it reasonable to choose, given what I know, given what I must guess or doubt, and given what I cannot know?” That’s a topic for another conversation.

~~~

BR: That’s much more precise than how I described it — thank you.

39. [...] –Risk v. Uncertainty: Barry Ritholtz looks at the distinction between risk and uncertainty. ” When we don’t know what any future outcome will be, but we understand the probability distribution — think of dice or a multiple choice exam — we have risk, but we do NOT have uncertainty. We never know what the roll of the dice will be, but we do know its one of six choices. Is that uncertainty? The answer is of course not — it is an unknown outcome with well-defined possibilities. We may not know precisely which outcome will occur in advance, but we do know its either 1, 2,3, 4, 5 or 6. Call that risk or an unknown future, but do not call that uncertainty. Consider alternatively what is the true definition of Uncertainty: That occurs when we have no idea of what the possible outcome might be. The probability distribution is unknown (or so extremely large as to functionally be the same as unknown). The so-called fiscal cliff is a perfect example — we know what the possible outcomes are, and we have a very good idea what their impact will be.” [...]

40. [...] What is the difference between risk and uncertainty?; Defining risk versus uncertainty; The stock market: risk vs. uncertainty (“Whereas risk is quantifiable randomness, [...]

41. Fazz Says:

“…The important point to note is that uncertainty is not defined by reference to having “no idea” of what the possible outcome might be (i.e. complete ignorance), but by reference to having “some idea”, albeit insufficient to enable us to precisely specify a unique probability distribution with absolute certainty. In some circumstances we can still guess at what the possible probability distributions might be, in other cases we cannot.

The question we are then faced with is: “How is it reasonable to choose, given what I know, given what I must guess or doubt, and given what I cannot know?” That’s a topic for another conversation.

~~~

BR: That’s much more precise… — thank you.

~~~

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