What are Risk and Uncertainty?
Uncertainty refers to a situation when there is one possible outcome of a decision but where the probability of occurrence of each particular outcome is not known or cannot be estimated.
Risk refers to a situation when the outcome of the decision is uncertain but when the probability of each possible is known or can be estimated. For example, coin toss, estimation of dividend from past performance. The greater the variability of the possible outcome, the greater risk involved.
Difference Between Risk and Uncertainty
Risk and uncertainty play an important role in the decision-making process. Each one of us as an individual or a Business entity or Government calculates the utility of prospects before decision making. The Prospects will go for a utility that has more payoffs.
The difference between risk and uncertainty is that risk shows a positive probability of an unpleasant outcome, whereas uncertainty does not provide a proper quantitative value or ranking of the viable outcome. However, in general terms, both are used to ascertain a similar situation, in which an aspect of the future cannot be determined beforehand. There are quantitative aspects related to them that create a difference between risk and uncertainty.
Risk and uncertainty's definition in economics is a bit different, and their difference is pretty clear. Frank H. Knight's definition of the terms in his book, Risk, Uncertainty, and Profit (1921) is still widely regarded as the apt definition of the two:
- Risk is present when future events occur with measurable probability
- Uncertainty is present when the likelihood of future events is indefinite or incalculable
Risk aversion: An individual can be a risk-averse which means he would not like to take a risk or he can also become a risk seeker which means he would like to take the risk given certain circumstances or he can be risk-neutral which means that he is indifferent between risky or certain situation. It is a natural human tendency.
Types of Risk
The risk may be classified as follows:
1. Speculative Risk or Dynamic Risk
When there is an equal chance or potential of gain and loss, it is called Speculative Risk. Generally, fluctuations in prices cause this type of risk. For example, the value of the stocks of a company that a person holds may go up or fall according to the performance of the company in the financial market.
2. Pure Risk or Static Risk
When there is a chance of loss, but no chance of gain, it is known as Pure Risk. For example, if there is a burglary in a shop, the owner will have to bear the financial loss. If there is no such burglary, there would not be a financial loss to the owner. But the owner does gain anything in either case. You can ensure pure risk.
3. Insurable Risks
Risks that can be predicted, estimated, and measured in terms of money are called Insurable Risks. These risks are generally transferable and can be insured.
Measurement of Risk
Risk can be measured by collecting large data of similar cases with the same risk and then divide the number of times the risk occurred by the number of similar cases. For example, if there are 700 homes in an area and 140 have been damaged by an earthquake in that year, then the risk rate is 140/700 or 20 percent. This kind of measurement is known as the Mathematical Value of Risk.
Sources of Uncertainty
Following are a few sources of uncertainty:
(1) Existing Facts and Future Plan
Here, already available facts and plans influence our idea of certainty and uncertainty of an event. For example, while constructing a rainwater harvesting system, there is uncertainty regarding the amount of rainfall we will get. But we can plan according to the past met data of the quantum of rainfall that area receives on an average. This data from the past lowers our uncertainty regarding the project.
(2) Uncertain Pattern
Here, the certainty of an event is definite but there is uncertainty about the pattern. For example, the met department predicts a sufficient quantum of rainfall in a year, but there is uncertainty regarding the distribution of the rain over different months. This uncertain information can cause losses.
(3) Bias of Self-Interest
Here, our past experiences of the events that occurred are adjusted according to our feelings and prejudices. It is known as the bias of self-interest and it can cause uncertainty among individuals.
(4) Belief about an Event Either Help or Harm
Uncertainty is maximum when we expect an event may either harm us or help us, with each being equally plausible.
What is Probability and How it Affects Uncertainty?
Generally, the chance of happening or not happening of an occasion is known as Probability. When the word ‘chance’ is used in any scenario, it demonstrates the presence of uncertainty. Most of the administrative choices are choices related to uncertainty.
Directors are required to form a few fitting presumptions for the future and base their choices on such presumptions. The decisions they make will determine the future of the organization and whether it will live up to its potential. The idea of 'uncertainty' or 'chance' is so common in everyone's life that it is almost impossible to categorically define it.
A French mathematician "Laplace" defined probability. According to him -
Probability is the ratio of the number of favorable cases among the number of equally likely cases.
Or, Probability = Number of favorable cases/Number of equally likely cases
To measure the element of uncertainty, probability theory provides numerical estimates. It helps the Directors of the business to take decisions under uncertain conditions with calculated risk.
Context and Application
Risk and uncertainty have been almost in every aspect of Business and decision making. It is a very practical subject as it influences the individual's lifestyle as well as the individual business entity. Risk and uncertainty have not been confined only with the Financial decision-making Processor only with the stocks and share trading but in almost all commercial activities. The objective of decision-makers is to calculate the risk and uncertainty associated with each outcome.
The topic Risk and uncertainty is studied under various discipline as mentioned below:
- Bachelor of Business Administration
- MBA - Finance
- Bachelor of commerce
- Master in Commerce
- Chartered Accountancy
- Company secretary
Apart from the discipline, Risk and Uncertainty are also referred to by professionals engaged in Banking and Financial Institutions as Financial Advisor. Experts engaged in Stocks and shares trading also refer to these topics for help in mitigating risk and uncertainty.
The following concepts are related to the topic of "Risk and Uncertainty":
- Risk Assessment and Risk Analysis
- Financial Risk
- Risk Identification
- Probability Distribution
- Factors of High-Risk
- Potential Risky Situations and Risk Analysis
- Objectives of Risk Management
Question: How to incorporate the additional risk that we are assuming in decision-making so that we should be compensated enough for the risk that we have taken?
Solution: One approach is to understand the certainty equivalent, certainty equivalent is essentially a factor or an approach that suggests that the wealth level of the decision-makers is indifferent between a risky and a certain choice. So, if one has two choices where one choice is risky and another choice is certain. The wealth level of these two choices becoming equal implies that there is a certainty equivalent situation.
Example: Lottery worth $10 having the outcome of winning $100,000. A person who purchased a lottery ticket worth $10 to win the lottery has two consequences. The first one is winning $100,000 and the other one is losing $10. The person has two choices either to hold the lottery ticket or to sell that lottery ticket to some other person at a certain Price. A Person who wants to avoid any further risk will go for selling the lottery ticket and the person who is a risk-taker will hold the lottery ticket. The difference in the result can be between winning $100,000 or losing $10, the price of that lottery ticket. There is always the risk and uncertainty of holding the lottery ticket in the hope of gaining $100,000. However, by selling the lottery ticket to some other person the uncertainty and risk are eliminated and the amount invested in purchasing a lottery ticket is compensated.
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