At the risk of getting philosophical, I am going to talk about risk, uncertainty, and the difference between the two. It matters. How you make decisions in your life is greatly influenced by whether outcomes are risky or uncertain, and how you make choices when considering each.
Both risk and uncertainty involve unknown outcomes, but risk is unique to statistical theory. Risk includes a probable distribution of outcomes. If I roll two dice, the outcome of the roll is unknown, but there are known probabilities for each. For example, rolling a 7 is far more likely than rolling a 2 or 12, since there are more combinations totaling seven (3/4, 4/3, 5/2, 2/5, 6/1, 1/6) than totaling two (1/1) or 12 (6/6).
Another illustration of the difference is car insurance. Insurance companies determine that taking a driver safety course reduces the probability of accidents, and so they might offer you a discount off your insurance premium for taking the course. An insurance company might determine through statistical analysis there is a lower probability of an accident and claim for drivers who took the course. The claim cost is more than (or at least equal to) the premium discount they offer. While there is uncertainty over a given accident, they have made fairly confident decisions about risk and made a correct business decision.
Now we will consider uncertainty, which has no known distribution of outcomes. Try to guess whether the S&P 500® Index will be higher or lower by close of trading on Friday of next week. If you could find a way to do this consistently, you hold the Golden Ticket! You would try to choose the future index value using a multitude of factors. The problem is that a varying number of decision makers buy and sell securities every day, and each uses innumerable, unknowable, and unmeasurable variables, including emotional considerations, and random future events (weather, terrorism, an early visit from Aunt Irma). You cannot estimate these variables accurately in advance, especially for outcomes of one week (but more discussion later for long periods, such as ten years).
You can manage risk; not so with uncertainty. You could choose to accept less risk by deciding to roll for a 7, instead of 2 or 12. Even so, the roll may end up being a 6 or some other number than 7. Understanding risk does not guarantee a predictable outcome. In fact, each roll of the dice is uncertain, even while the risk of each roll is known and quantifiable. In this way, uncertainty and risk are related. However, understanding the difference can be crucial when making lifelong plans or making finance-related decisions. Quantify risk, but embrace uncertainty in your life. In the words of Ned Ryerson, “It’s all one big crapshoot any-who!”
