I Say Risk, You Hear Uncertainty

When I say “risk” and you say “risk,” chances are high we don’t mean the same thing.

The finance industry defines risk as something measurable.

It is variability within a set of known limits.


You may have heard it referred to as standard deviation or even volatility.

Ultimately, it represents how much an investment wiggles over time.

I’m an adviser who talks to humans. I also happen to be human.

From my experience, I know humans outside the financial world define risk differently.

In everyday life, we tend to think of risk as uncertainty, or what is left over after we have thought of everything else.

With uncertainty comes variability within a set of unknown limits

It’s the stuff that comes out of left field, like Nassim Nicholas Taleb’s black swan events.

Because we can’t measure uncertainty with any sort of accuracy, we think of risk as something outside our control.

We often connect it to things like running out of money in retirement or ending up in a car crash.

But how did we end up with two such completely different definitions of the same thing?

My research points to an economist named Frank Knight and his book “Risk, Uncertainty and Profit.

In 1921, Mr. Knight wrote: “There is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known.”

When a risk is known, it is “easily converted into an effective certainty,” while “true uncertainty,” as Knight called it, is “not susceptible to measurement.”

This difference in definitions may seem like a small thing, except that it leads to two different sets of expectations.

When expectations are not met, the result can be bad behavior. In this case, bad investment behavior.

Imagine for a moment that it is 2005.

You have completed the kind of risk tolerance questionnaire that financial advisers often ask you to fill out before recommending investments.

You then sign off on a portfolio based on your answers, comfortable that you are taking the perfect amount of risk.

Then, one morning, you wake up.

It’s 2008, and the markets are in free fall.

The risk that felt just right three short years ago doesn’t feel so right anymore, and you sell everything.

I’m betting that the level of risk you agreed to in 2005 did not mentally translate into all of the wiggling that took place in 2008.

I’m also betting that if you heard a term like “risk management model,” you really thought, “uncertainty management model.”

Unfortunately, no financial firm offers uncertainty management

Solving this problem doesn’t require a new definition. We just need to shift our thinking when we hear someone in finance mention risk.

We need to remember, that person isn’t talking about the odds we’ll lose everything, but about something that fits in a box.

I suspect that is why financial professionals sound so confident when they talk about managing our risk.

In their minds, managing risk comes down to a formula they can fine-tune on their Dial-A-Risk meter.

In our minds, we have to learn to separate the formula from the unknown unknowns that cannot be accounted for in any model or equation.

Once we learn to recognize that we are not talking about the same thing, we can avoid terrible disappointment and bad behavior when financial risk shows up again.

And it will.


This article originally appeared in the New York Times

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Carl Richards


Carl Richards is a Certified Financial Planner and a columnist for the New York Times, Morningstar magazine and Yahoo Finance. He is author of 2 books, The Behavior Gap & The One-Page Financial Plan. Carl lives with his family in Park City, Utah. You can find his work and sign up for his newsletter (which has an international audience) at www.behaviorgap.com/

'I Say Risk, You Hear Uncertainty' have 1 comment

  1. February 26, 2016 @ 11:25 am Hamish

    As a finance guy we measure risk in terms of standard deviations e.g. we project a certain level of revenue and expenditure and then risk adjust for the likelihood of the actual varying from what is projected.

    More recently I have moved into operations where we use likelihood x consequence to determine risk. In this context there are the known knows, the known unknowns and the unknown unknowns.

    We endeavour to mitigate the known knowns and unknowns by applying various controls. This is where policies, procedures and systems underpinned by culture is critical. Part of the risk is that we have incorrectly estimated the likelihood, the consequence (or both), or perhaps more importantly – the effect of the controls in mitigating the risk.

    So in a property development sense, the uncertainty might be whether there is any hazardous material on site, and if so – how much there is. The control is to budget for it. The risk is that if they find any, the actual cost of removal is more than you budgeted.

    Also when it comes to operational risk management, it is important not only to implement the controls, but also to document what you have done. Otherwise when things do go wrong you can at least refer to what you said you would do and hopefully prove that you did at least what a reasonable person in the circumstances should have done.


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