Radical uncertainty

Published on August 19, 2020 by Entrima

Risk is not a synonym for uncertainty, because risk can be quantified, whereas uncertainty cannot. Risk quantification is based on a formula including ‘probability’ and ‘effect’. In case of uncertainty, either the likelihood to a certain outcome cannot be identified, or the consequence of that outcome. When both chance and significance are unknown, one can refer to ‘radical uncertainty’.

When performing risk management companies often focus on the known knowns, while the known unknowns or unknown knowns might be more important. Ultimately the unknown unknowns are most critical, but simply impossible to be managed. After all, the known knowns concern the things we are aware of and understand, whereas the unknown unknowns concern the things we are neither aware of, nor understand. The unknown knowns are the things we understand but are not aware of, while the known unknowns are the things we are aware of, but do not understand.

Risk is not identical to the maximum loss. The way risk is calculated makes risk typically turn out to be less than the maximum loss. Consider, for instance, two people making a bet concerning the tossing of a coin. Suppose they bet for ten dollar. One choses head, while the other opts for tail. In this case, the maximum loss is obviously ten bucks. The expected value, however, is fifty percent of ten dollar, namely five dollar. The latter forms the fundament to quantify exposures. One could say that the expected value (or risk) is five, whereas the maximum loss is ten. Analogously, a market participant, like an investor or speculator, may have acquired a barrel of oil at 65.00 dollar. On the basis of a calculation, the value at risk may turn out to be 8.30 dollar. All-in-all, risk and maximum loss are absolutely not the same. Usually, one can lose more money than the numbers generated by a risk quantification model.