Why risk and uncertainty are different in markets?

Stock Market | Published on 24th July 2018 | 514

We often use the terms risk and uncertainty interchangeably. Most investors equate risk and uncertainty when it comes to investments. In reality, there is a very significant difference between the two of them. Did you know that when you make an investment decision, there is a risk element and there is an uncertainty element to it? Both pertain to the future and both look like the inverse of certainty. The difference is the key to managing risk and uncertainty in your investment decisions.

Risk is the potential of loss

Before we understand risk, we need to first understand what loss is. Loss in the context of your investments is the probability of a bad thing happening or a good thing not happening. You must have often seen that a frontline stock announces a growth in profits and yet the price falls in the stock market. Have you ever wondered why that happens? The answer is the perception of risk. For example, if the market expected the profits to grow by 25% and the actual growth came in at just 18%, then it will be defined as risk. Since risk increases in this case, the price of the stock will go down. Let us look at a slightly different situation. Suppose the market expected the profits of a company to fall by 15% in the quarter. If the profits fell by only 10%, then it will be seen as a reduction of risk. You may be surprised but the stock normally goes up in these cases.

From the stock market point of view, risk is what matters since it can be measured; understood and managed. Investing classify risk into two categories viz. systematic risk and unsystematic risk. Systematic risk is the market level risk that impacts all businesses equally. Risk of the market is measured by the Beta of the stock. Macro factors like political uncertainty, trade war, higher inflation, rising interest rates, rising trade deficit all represent systematic risk factors. Then, what is unsystematic risk? Weak margins, tough competition are all examples of unsystematic risks. Risk is something that can be measured based on past experience and that is where risk differs from uncertainty.

Uncertainty just looks like risk, but it is different…

Uncertainty is the absence of certainty. Thanks but no thanks! That really does not help you or enlighten you too much. To be more precise, uncertainty is where the occurrence of an event is not certain and also it is likely outcomes are not certain. Since outcomes are uncertain, it becomes more complex to define uncertainty or to measure it. Uncertainty, therefore, reflects a situation where you are not sure of the outcomes. Gujarat state may be earthquake prone, but it is uncertain whether the earthquake will hit the region in the next 5 years or 10 years or the next 25 years. The event is technically possible at any point of time. But whether it is probable or not can be determined only when there can be some certainty about the range of the outcomes. That is when an uncertainty becomes risk.

Lesson 101 – How risk is fundamentally different from uncertainty…

Risk has a lot more of relevance to financial planning and investment strategy. That is because risk has got to be managed. Uncertainty cannot be managed.

· Risk is measurable uncertainty while uncertainty is immeasurable risk. What this basically means is that risk is a subset of uncertainty. The extreme component of risk that cannot be measured and therefore unquantifiable is uncertainty.

· Uncertainty represents a situation where future events or the course of futures events are largely unknown. Therefore, the outcomes are also unknown. When you cannot know outcomes, it is hard to assign probabilities to their occurrence. This is the essential difference. Risk can be reduced to probabilities and hence can be planned and managed. Uncertainty cannot be reduced to probabilities. What is the probability that there will be an earthquake in Mumbai tomorrow? You cannot assign any probability to an event that is uncertain.

· Typically, Black Swan events as defined by Nassim Nicholas Taleb represent uncertainty because their probability of occurrence is very low or at least appears to be too hazy at this juncture. Major failures are more likely in the face of uncertainty than in the face of risk.

· Risk is in between extremes. Risk is related to uncertainty in the sense that there is still uncertainty over the occurrence of an event. However, these are based on known factors. Therefore, likelihoods can be assigned and managerial decisions taken accordingly. You can assign probability to 4% growth in GDP versus 6% growth in GDP versus 8% growth in GDP.

· For a business perspective, risk can be managed and hence can be controlled. In a portfolio, the unsystematic risk can be managed by diversifying while systematic risk can be reduced or managed through beta hedging versus Nifty futures. Uncertainty cannot be measured and therefore cannot be managed. So what do you do? The answer is you take insurance. That is where the role of insurance comes into uncertainty. There is no insurance against risk but there is insurance against uncertainty! From an investment management point of view, that is the core difference.