User:Risk

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Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term "risk," as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. ... The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. ... It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We ... accordingly restrict the term "uncertainty" to cases of the non-quantitive type.:[1]}}

Thus, Knightian uncertainty is immeasurable, not possible to calculate, while in the Knightian sense risk is measurable.

Another distinction between risk and uncertainty is proposed by Douglas Hubbard:[2][3]

Uncertainty: The lack of complete certainty, that is, the existence of more than one possibility. The "true" outcome/state/result/value is not known.
Measurement of uncertainty: A set of probabilities assigned to a set of possibilities. Example: "There is a 60% chance this market will double in five years"
Risk: A state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome.

Measurement of risk: A set of possibilities each with quantified probabilities and quantified losses. Example: "There is a 40% chance the proposed oil well will be dry with a loss of $12 million in exploratory drilling costs".

In this sense, one may have uncertainty without risk but not risk without uncertainty. We can be uncertain about the winner of a contest, but unless we have some personal stake in it, we have no risk. If we bet money on the outcome of the contest, then we have a risk. In both cases there are more than one outcome. The measure of uncertainty refers only to the probabilities assigned to outcomes, while the measure of risk requires both probabilities for outcomes and losses quantified for outcomes.

Risk attitude, appetite and tolerance

The terms risk attitude, appetite, and tolerance are often used similarly to describe an organisation's or individual's attitude towards risk-taking. One's attitude may be described as risk-averse, risk-neutral, or risk-seeking. Risk tolerance looks at acceptable/unacceptable deviations from what is expected.Template:Unclear inline Risk appetite looks at how much risk one is willing to accept. There can still be deviations that are within a risk appetite. For example, recent research finds that insured individuals are significantly likely to divest from risky asset holdings in response to a decline in health, controlling for variables such as income, age, and out-of-pocket medical expenses.[4]

Gambling is a risk-increasing investment, wherein money on hand is risked for a possible large return, but with the possibility of losing it all. Purchasing a lottery ticket is a very risky investment with a high chance of no return and a small chance of a very high return. In contrast, putting money in a bank at a defined rate of interest is a risk-averse action that gives a guaranteed return of a small gain and precludes other investments with possibly higher gain. The possibility of getting no return on an investment is also known as the rate of ruin.

Risk as a vector quantity

Hubbard also argues that defining risk as the product of impact and probability presumes, unrealistically, that decision-makers are risk-neutral.[3]Template:Page needed A risk-neutral person's utility is proportional to the expected value of the payoff. For example, a risk-neutral person would consider 20% chance of winning $1 million exactly as desirable as getting a certain $200,000. However, most decision-makers are not actually risk-neutral and would not consider these equivalent choices. This gave rise to prospect theory and cumulative prospect theory. Hubbard proposes to instead describe risk as a vector quantity that distinguishes the probability and magnitude of a risk. Risks are simply described as a set or functionTemplate:Vague of possible payoffs (gains or losses) with their associated probabilities. This array is collapsed into a scalar value according to a decision-maker's risk tolerance.
  1. Frank Hyneman Knight "Risk, uncertainty and profit" pg. 19, Hart, Schaffner, and Marx Prize Essays, no. 31. Boston and New York: Houghton Mifflin. 1921.
  2. Douglas Hubbard "How to Measure Anything: Finding the Value of Intangibles in Business" pg. 46, John Wiley & Sons, 2007.
  3. 3.0 3.1 Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to Fix It, John Wiley & Sons, 2009.
  4. Federal Reserve Bank of Chicago, Health and the Savings of Insured versus Uninsured, Working-Age Households in the U.S., November 2009