What is Risk?

What immediately comes to mind is “Should I risk it? Should I double down?” Risk conjures up images of daring soldiers, cool hedge fund managers, and wild teenagers. Books and movies immortalize risk takers who succeed. Luke Skywalker turns off his computer targeting system. James Bond takes on Dr. No’s whole army. Roald Dahl’s Matilda stands up to Miss Trunchbull. This sense of risk—weighing the possible bad outcomes and deciding whether to push forward—is deeply embedded in human intuition.

From an evolutionary standpoint, it makes sense. If I attack the woolly mammoth will I die? If I do not will I starve? When death is the bad outcome, there is little evolutionary reward for mathematical calculation of the upside. Fortunately, the nature of civilization has changed dramatically in the last 10,000 years in the violent death rarer–although still all too common in some places. Unfortunately, 10,000 years is an an evolutionary blink of an eye, and humans’ traditional, intuitive, tools for evaluating risk are inappropriate for the kinds of decisions that people are often making today. This is particularly true with financial decision making where both the upside and downside can be ethereal and in the distant future.

And then there is the word itself-risk, what exactly do we mean when we say risk. Frank Knight astutely pointed out the distinction between two kinds of risks: “risk” and “uncertainty.” Risk is an unknown outcome that is measurable with mathematical model like the roll of a die. Uncertainty is immeasurable: the outcome of a sea battle. This is a very useful distinction because it separates what we can model with a degree of certainty from the “unknown unknowns” or “black swans.”

While the distinction between risk and uncertainty is useful, it lacks congruence with our intuitive sense that risk involves a chance of loss. Doug Hubbard acknowledges this when he defines risk as “a state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome” in his book How to Measure Anything: Finding the Value of Intangibles in Business and The Failure of Risk Management. This definition “feels” right. After all, people do not think of spending time and money on risk management systems to maximize the possibilities that things will go well. Risk management has traditionally been all about avoiding the really catastrophic outcomes. In some contexts, risk management is just about buying insurance.

While I will continue to use the term “risk management” for lack of a good substitute, I find it useful to avoid the term risk because of its negative connotations. I prefer to think of measurable and immeasurable uncertainty. If the next impact of a possible outcome is damaging, it is a threat. If it is beneficial it is an opportunity.

The challenge with managing uncertainty is two-fold. First one must make a judgment as to what is portion of the uncertainty is quantitatively measurable and what portion is immeasurable. Once this determination is made, only then can one set out to mitigate threats and exploit the opportunities. This process will always be qualitative in nature, but if the opportunities or threats are measurable, it may also be quantitative.

There are two big places to go wrong in this process. The first is to apply mathematical models to immeasurable uncertainty. This is a huge business in the financial industry. Complicated formulas and higher mathematics are so impressive, and the people who use them are so smart, that they must tell us something. More effort and complexity must give us more understanding. This unfortunately is clearly not the case. The second is place that this process goes wrong is when it assumes that what it says is what is heard. With any analysis, what is said is not what ultimately important. What is ultimately important is what is heard. A risk management system can say there is a 1% chance of a major hurricane this year. What is heard is that there is NO chance. It can say that there is a 99% chance that a dam will hold. What is heard is that the dam will hold. In short, even if the models are correct, the interpretation of the models still poses a threat.

While much has been said about the threats that various risk management techniques have posed, they also provide real opportunities to be exploited. For every case where systematic assessment of threats and opportunities has gone astray there are two where it could have provided real benefit. In the past, too much emphasis has been placed on removing uncertainty. This has led to a market for people and businesses who promise just that. This market is as old as the first fortune teller. The opportunities are out there for people that are willing to take the time to distinguish between measurable and immeasurable uncertainty, rigorously model what is measurable, and resist the urge to have an opinion on the immeasurable. Socrates was wrong what he said “The only true wisdom is in knowing you know nothing,” but he was right on when he said, “Wisdom is knowing how little we know.” As Confucius said, “True wisdom is knowing what you don’t know.” I would go a step further and say that true wisdom is more than knowing, it is also acting in a way that exploits both what you know and know you do not know.