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Defining Risk Versus Uncertainty

Posted By Barry Ritholtz On December 10, 2012 @ 7:05 am In Mathematics,Philosophy,Really, really bad calls | Comments Disabled

Longtime readers will recall that I find the Uncertainty meme to be mostly silly (see this [1] and this [2]). 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 [3], 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 [1] (Bloomberg,  November 9, 2010)

There’s nothing new about uncertainty [2] (Washington Post, July 7 2012)

Mauboussin on ‘The Success Equation’ [3] (November 20th, 2012)


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2012/12/defining-risk-versus-uncertainty/

URLs in this post:

[1] this: http://www.bloomberg.com/news/2010-11-10/kiss-your-assets-goodbye-if-certainty-reigns-commentary-by-barry-ritholtz.html

[2] this: http://www.washingtonpost.com/theres-nothing-new-about-uncertainty/2012/07/06/gJQA5hnmUW_story_1.html

[3] Bloomberg TV: http://www.ritholtz.com/blog/2012/11/mauboussin-on-the-success-equation/

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