Risk versus Uncertainty

What are the odds that your new idea will succeed?  If it does, what will the return to you be?

One of the problems that we have in business (and life!) is that we often can’t know the answer to questions like this in advance.  And this drives us nuts.  Consequently, a lot of people invest a great deal of effort into reducing uncertainty.  There are two problems with this approach.  The first is that we often don’t understand uncertainty very well, and the second is that profitably opportunities only exist where outcomes are genuinely uncertain.

Frank Knight wrote about this in 1921 in a great book called Risk, Uncertainty and Profit (which you can read here).  He distinguished between two types of uncertainty.  The first type is when we know the potential outcomes in advance, and we may even know the odds of these outcomes in advance.  Knight calls this type of uncertainty risk.

An example of risk is rolling a pair of dice.  Before we roll, we know in advance what the odds are for each possible outcome (provided that the dice are fair).  Knowing these odds forms the basis for all of the games of chance that we can play.  Dice are relatively simple, cards a bit more complicated, but we can know all of the odds with them in advance.

Dice for various games, especially for roleplaying games. Español: Dados en forma de poliedro regular (de 4, 6, 8, 10, 12, 20 y 100 caras) y el dado típico de 10 caras. (Photo credit: Wikipedia)

Genuine uncertainty is different.  This occurs when we don’t even know the possible outcomes in advance, let alone their probabilities.  Genuine uncertainty occurs in complex systems, where lots of actors interact over time – the economy, for example.

The important point that Knight makes is this: real opportunities for profit only exist in the face of genuine uncertainty.   Which means that if we want to innovate successfully, we not only have to deal with uncertainty, we must seek it out.

The Problems of Uncertainty

We’re not the most rational decision-makers in the first place, and confusing uncertainty with risk makes things worse.  Here’s how:

• We act like everything is just a risk.  Here is how Knight puts it:
  

  Business decisions, for example, deal with situations which are far too unique, generally speaking, for any sort of statistical tabulation to have any value for guidance. The conception of an objectively measurable probability or chance is simply inapplicable. The confusion arises from the fact that we do estimate the value or validity or dependability of our opinions and estimates, and such an estimate has the same form as a probability judgment; it is a ratio, expressed by a proper fraction. But in fact it appears to be meaningless and fatally misleading to speak of the probability, in an objective sense, that a judgment is correct.

  When we act like everything is a risk, we greatly increase the chance of failure.  However, the opposite can also be a problem:

• We act like everything is unknowable. Uncertainty often gets blamed for inaction.  Barry Ritholtz takes aim at the problems with this:
  

  It finally dawned on me what the uncertainty trope is all about. It took a conversation with a nervous chief executive to reveal it, but I teased out the answer.

  Most of the time, people exist in a happy little bubble of self-created delusion. We engage in selective perception, seeing only the things that agree with us. Our selective retention retains the good stuff and disregards most of the rest. In our minds, we are all younger, better-looking, slimmer, with more hair than the camera reveals.

  In short, we construct a reality that bears only passing resemblance to the objective universe.

  During those brief instances when the facade fades, the curtain gets pulled back and the ugly reality becomes clear. We get a glimmer of understanding about our own lack of understanding. That’s when the grim reality of the human condition is revealed — and it terrifies us.

  The next time you hear someone mention uncertainty, ask yourself this: How much less do they actually know about the future today vs. what they knew last week or year? How much less do they think they know?

  We can’t use not knowing as an excuse to not act – because we never know.

It seems like we either suppress uncertainty, and act overconfidently, or we overemphasise uncertainty, and don’t act at all.  Both are bad outcomes.

How to Respond to Genuine Uncertainty

Managing risk is pretty straightforward.  You match up your investment to the odds of it paying off.  Managing uncertainty is trickier.

Fortunately, there are a few things that we can do.  It’s important to cope with uncertainty effectively, because doing so allows us to go where the opportunities are.  Here are some strategies:

1. Aggregate.  When I get in my car to drive to work tomorrow, it’s impossible to know if I’ll have an accident or now.  And yet I have car insurance.  How can this be?Insurance works because when you add up enough individual cases of uncertainty, you might end up with probabilities.When we’re talking innovation, this means that Linus Pauling was exactly correct when he said that the best way to have a great idea is to have a lot of ideas. Volume can reduce uncertainty.  This is what venture capital firms do too when they make a wide range and high number of investments.
2. Seek out uncertainty to increase the chance of hitting it big.  If you enter the lottery, the odds of winning are higher than the payout – it’s a sucker bet.  Innovation is the opposite – the odds of winning are lower than the payout – it’s a positive feedback loop.  Taking advantage of this is a smart play.  This is the process of looking for positive outliers.
3. Understand that when we face uncertainty, some ideas will fail.  But this is what drives progress.  William Janeway has an interesting take on this in his book Doing Capitalism in the Innovation Economy:
   

   Schumpeter’s process of creative destruction can only proceed by trial and error. We see that which is created through the lens of survivors’ bias and ignore the “hopeful monsters” that economic evolution has spawned and left behind in metaphorical emulation of Darwin’s process of natural selection. No doubt every one of them was launched on the basis of an exercise in forecasting future revenues, costs and an expected value to be compared with a rough estimate of the cost of capital. As Schumpeter well knew, the wastage is the measure of the inescapable uncertainty that attends the practice of doing capitalism: We need only visualize the situation of a man who would … consider the possibility of setting up a new plant for the production of cheap aeroplanes which would pay only if all people who drove motorcars could be induced to fly. The major elements in such an undertaking simply cannot be known … Neither error nor risk expresses adequately what we mean.

   Waste measures uncertainty!

It’s important to understand the distinction between risk and uncertainty.  The two situations require different responses – and if we confuse the two, we won’t use the right approach.

And that really increases the risks we face!

Related articles

• There’s No Innovation Without Uncertainty
• Defining Risk Versus Uncertainty