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Home » All, Decision-Making

Risk versus Uncertainty

By on October 14, 2011 – 7:53 am  2 Comments

Peter R. Worrell, MAPP '09 is the Managing Director/CEO of The Bigelow Company LLC. Bigelow, originally established in 1935, is an independently owned merger and acquisition advisory firm whose clients are exclusively highly successful private entrepreneur owned enterprises. Worrell is passionately committed to the practical application of positive psychology to optimize entrepreneurs' decision making in the domain of risk. Full Bio. Peter's articles are here.



Background… Noise… Rumor… Data… Information… Knowledge… Judgment… Wisdom?

We are deluged with data, but is more data and more rapidly acquired data actually contributing to higher quality decisions? For example does more data help entrepreneur owner-managers drive enterprise value for stakeholders? Or are we failing to understand how to strategically allocate resources in our markets because we are misinterpreting the information? One of the most frequent errors we observe owner-managers, and probably many others, making is the failure to distinguish Risk from Uncertainty.

There is extensive literature on Risk and Uncertainty. The difference between them is clear and simple to evaluate.

With Risk, the actual outcome of a decision may be unknown, but the distribution of the probabilities of alternative outcomes is measurable. Decision-making clarity is achieved by assessing the most likely outcomes for each alternative: Probability multiplied by likely outcome = expected value.

In the domain of Uncertainty, this is not true, because in Uncertainty (by definition), each situation one encounters is in effect immeasurable. It is fresh or unique. There is no reliable platform to support traditional strategic risk analysis. Each scenario becomes exposed to guesswork and conjecture, which only promotes argument and confusion. Owner-managers and CEOs, who have long preached against “surprise” as the worst outcome of any management effort, now find themselves living with it.

In the data rich world we live in today, choice is abundant. Yet empirical research has shown that frequently, in the anxiety of too many choices, we feel overwhelmed. Often what we “know” is based on only a modest level of understanding. Paralyzed by the complexity of decisions they have to make, some people attempt to solve this conundrum by seeking out even more data. The result is an overabundance of unconnected facts with no way to see the alternatives clearly.

At the Crossroads

Nonetheless, despite uncertainty, we have to act. Most of us don’t work in laboratories where we can stop the experiment at will. We have to deduce answers on the fly from the data at hand, limited though it may be. The vast majority of all of our decisions are (and will always be) made on imperfect or incomplete information. Some believe that more information will provide a more clear view of the future, and hence improve their decision making. The reality is that additional information in the domain of Uncertainty often clouds the decision-making process.

This is the Age of the Entrepreneur. We recognize that thinking about these issues requires an uncommon degree of honesty. But life, like markets, surely offers the highest benefits to those who can calculate and take on Risk, where appropriate, and otherwise accept the existence of Uncertainty. So if you truly understand the difference, you will recognize which domain you are in, and thus what set of tools you can best employ.


 
References

Kahneman, D., & Tversky, A. (Eds.). (2000). Choices, Values, and Frames. Cambridge University Press.

Schwartz, B. (2004). The Paradox of Choice: Why More Is Less. New York: Ecco.

Images
Do we inherently like risk? courtesy of Adam Cutler
Crossroads courtesy of Lori Greig

2 Comments »

  • Smack MacDougal says:

    Risk is what you put at stake. Uncertainty is what one has about the actual outcome yet to get experienced. Danger is

    You risk your money in investment. The danger is you lose it all. You’re uncertain as to getting return on your investment or the danger becoming real.

    Unless you’re dealing with a closed system like blackjack or an open system with closed outcomes like roulette, you cannot calculate the odds of outcomes.

    Your belief about what risk means is false. Risk is what you put at stake. It is not a measurable “distribution of probabilities of alternative outcomes.”

  • Pete Worrell says:

    Smack:

    Thanks for making this comment.

    I can see that your note is clearly how you “feel”, and I cannot debate your subjective feelings.

    But strictly speaking from a behavioral finance perspective, what you write is not factually correct. Most historians of economics believe that the definition referred to was was defined as early as Bernoulli in the 15th Century. His definition (adopted by behaviorists) is that Risk IS a measure of probabilities (naturally only adding to 1.00 in total) multiplied agains potential outcomes, yielding an Expected Value.

    The domain of Uncertainty, on the other hand, is by definition unknowable, as distinct from Risk. Frequently, seasoned successful entrepreneurs (my intended targeted readers) confuse the two– in fact I suppose you could say all of us business owners or investors are susceptible to confuse the two!

    A terrific history of risk is in a book by Peter Bernstein titled Against the Gods. Of course, Kahneman & Tversky’s Prospect Theory (1979) is also THE foundational work of all scholarship in the intersection of psychology and economics.

    Hope this is helpful.

    PRW

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