Risk vs Uncertainty

For a long time I was assuming that risk and uncertainty are the same. But they are not. Risk are known unknown. Uncertainties are unknown unknowns. Former U.S. secretary of defense Donald Rumsfeld writes

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 know we don’t know. But there are also unknown unknowns. These are things we don’t know we don’t know.

In the book The Personal MBA – Josh Kaufman writes

Risk are known unknowns. If you’re planning to pick up a friend from the airport, the probability that their flight will arrive several hours late is a Risk – you know in advance that the arrival time can change, so you plan accordingly.  Uncertainty are unknown unknowns. You may be late picking up your friend from the airport because a meteorite demolishes your car an hour before you planned to leave for the airport. Who could predict that? You can’t reliably predict the future based on the past events in the face of Uncertainty.

In the book More Than You Know: Finding Financial Wisdom in Unconventional Places – Michael Mauboussin writes

Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like. So games of chance like roulette or blackjack are risky, while the outcome of a war is uncertain. Knight said that objective probability is the basis for risk, while subjective probability underlies uncertainty.

In the book The Signal and the Noise – Nate Silver writes

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.

In an interview with Safal Niveshak – Prof. Sanjay Bakshi tells

Risk, as you know from Buffett, is the probability of permanent loss of capital, while uncertainty is the sheer unpredictability of situations when the ranges of outcome are very wide. Take the example of oil prices. Oil has seen US$ 140 a barrel and US$ 40 a barrel in less than a decade. The value of an oil exploration company when oil is at US$ 140 is vastly higher than when it is at US$ 40. This is what we call as wide ranges of outcome. In such situations, it’s foolish to use “scenario analysis” and come up with estimates like base case US$ 90, probability 60%, optimistic case US$ 140, probability 10%, and pessimistic case US$ 40, probability 30% and come up with weighted average price of US$ 80 and then estimate the value of the stock. That’s the functional equivalent of a man who drowns in a river that is, on an average, only 4 feet deep even though he’s 5 feet tall. He forgot that the range of depth is between 2 and 10 feet.

How to deal with uncertainties?

After reading this I understood that risk and uncertainty are different. The next question is how to deal with uncertainty? Naseem Taleb a former hedge fund manager and author of the book The Black Swan uses the analogy of black swans to explain uncertainty. Black swans are rare, high impact, and unpredictable events. Black swans could be negative or positive.

He advises to avoid exposure to negative black swans and seek exposure to positive ones. Titanic is an example of a negative black swan.

Another example of negative black swans is the bankruptcy of Lehman Brothers in 2008. Before going bankrupt in 2007 Lehman Brothers had a leverage ratio of about 33 to 1. This means that for every $1 of its capital it owes $33 to others.

In order to avoid this situation it is better not to be overconfident and avoid crazy leverage. The next question is where do you find positive black swans. In his talk Understanding the Universe of the Unknown and the Unknowable – Sanjay Bakshi writes

For example take the movie business, or the book publishing business, or the drug discovery business or the venture capital business or the private equity business. While these businesses have their specific risks, they also have exposure to positive black swans.

In fact this is what venture capitalists in Silicon Valley do. They bet on lots of companies so that they are diversified. They hold on to the winners for a very long time. Here are the list of companies that were successfully funded by Greylock Partners.

1. Facebook
2. Airbnb
3. Workday
4. Zipcar
5. Wealthfront

In order to increase your odds of meeting positive black swans in your life you need to be prepared and position yourself were they proliferate a lot.

“Chance favors the prepared mind.” – Louis Pasteur