Risk is when the odds or probabilities of future events can be estimated.
Uncertainty is when the list of possible future events is unknown, so their odds of occurring cannot be estimated.
So how do we make decisions under risk versus uncertainty?
Risk and Insurance
Riding in a car is risky. We could get into an accident, and if the accident is severe, we might die. Most of the time, we arrive safely at our destination, which is why we are willing to assume the risk of car travel.
When we travel by car, there are a few possible outcomes. We could reach our destination, or we might not. If we don’t arrive where we want to go, it could be because the car broke down, or we got into an accident, or even more tragic, we were in an accident and died.
According to the Insurance Information Institute, the odds of an individual dying in an automobile accident in the next year is 1 in 47,852. The odds of dying in an automobile accident during one’s lifetime is 1 in 608.
Riding in a car is an example of risk because we know the possible outcomes and their probability of occurring.
Because the odds of risky events can be estimated, we can protect against those adverse outcomes by purchasing insurance, such as automobile or life insurance. Insurance allows us to receive compensation when an insured event, such as an automobile accident, happens.
Insurance companies have actuaries who estimate how frequently specific events occur. While they don’t know which of their insured parties will have an automobile accident, by insuring a large enough pool of individuals, they can estimate how many automobile accidents will occur in a given year and what it will cost to fix the damages. Insurance companies charge a high enough insurance premium to their policyholders so that aggregate premiums cover the annual losses and allow for a profit.
Something is uncertain if we don’t know what could happen or we don’t know the odds of what will happen. Uncertainties are open-ended with many possibilities. Risks have a narrow range of outcomes with odds that can be estimated. We can insure against risks but not uncertainties.
Risk Versus Uncertainty
- Narrow range of outcomes
- Probabilities can be estimated
- Can purchase insurance protection
- Wide range of unknown outcomes
- Can’t estimate probabilities
- Can’t purchase insurance
Making Decisions Under Risk
Our approach to decision making should differ based on whether we are dealing with a risky situation or one that is uncertain.
We will first look at decision making under risk, and we will then consider decision making under uncertainty.
Economist Alison Schraeger shares a three-step process for managing risk.
- Decide what we want.
- Determine if there is a risk-free or low-risk option to get what we want without being harmed.
- If there isn’t a risk-free or low-risk option, then decide how much risk we are willing to assume to get what we want. What is our probability of success? How likely are we to be harmed?
We face this decision-making process in finance. If we want to save enough for a down payment on a house, we have to decide how to invest those savings.
We might invest the savings in a more risky asset class such as stocks or a less risky asset class such as short-term bonds. Stocks are riskier than bonds because stocks have a wider range of potential outcomes, including a higher probability of suffering losses.
Investing in short-term bonds means we can be more confident we will reach the savings goal within a certain number of years because the range of potential returns for short-term bonds is narrow. Short-term bonds are the low-risk option.
Investing in stocks might allow us to reach the desired down payment goal sooner if stocks perform well. But stocks might also fall significantly in price after we have saved for several years, which would cause us to miss our goal.
We can calculate the odds of reaching our down payment savings goal by investing in stocks versus bonds because there are more than one hundred years of historical returns for stocks and bonds to use to estimate the probabilities.
Our ability to calculate probabilities of various outcomes allows us to make informed probabilities when facing risky situations. That is not the case with uncertain situations so our decision approach is different.
Making Decisions Under Uncertainty
In the early 1950s, behavioral economist Leonard Jimmy Savage introduced a framework for making decisions under uncertainty called “minimax regret.” The idea is to minimize our maximum regret.
Regret is a subjective feeling. Regret management is not the same as minimizing our potential monetary losses as in the house down payment example. In that example, we could estimate the probability of losing money investing in stocks versus bonds and make a risk-based decision.
With uncertainties, we don’t know the probabilities, so we do our best to avoid situations where we could be ruined and experience tremendous regret.
“The concept of regret is a much more powerful and flexible concept than mere loss because it is entirely subjective. But that’s exactly what makes the strategy human. That’s exactly what makes the strategy real.”Ben Hunt
The 2020 coronavirus pandemic is an example of making decisions under uncertainty. When the pandemic first hit, we didn’t know the probabilities of getting sick, and if we fell ill, we didn’t know the odds of dying. We also didn’t know who was infected or even how we could get infected.
“In the face of uncertainty we cope as humans, we don’t optimize.”Mervyn King, former Bank of England Chair
The situation was highly uncertain. In those circumstances, the minimax regret decision was to shelter in place as much as possible until we had more information on fatality statistics.
Minimizing our regret is not an optimization problem. It is a behavioral coping mechanism for dealing with uncertainty.
Confusing Risk Versus Uncertainty
Economic professor Erik Angner in his textbook on behavioral economics, shares an example of the importance of distinguishing between risk and uncertainty when making a decision.
The example involves regulating a new and potentially lethal chemical substance for which there is little data available.
Regulators might approve the substance if they use a risk-based approach by insisting on assigning probabilities to the various outcomes. In doing so, they might estimate a low probability of harm and that the potential benefits offset the risks.
If regulators use a minimax regret approach, they might ban or heavily regulate the substance until there is more evidence of its safety because the probabilities are unknown. The potential regret from losing lives is too great.
Whenever we need to make a decision, we should consider whether the potential outcomes or probabilities are known so that we can distinguish between a risky situation or one that is uncertain.
If the range of potential outcomes is narrow, and we know the probabilities then we can take a risk-based approach to decision making like the one proposed by Alison Schraeger above.
If the potential outcomes are unknown, nor their probabilities, then we must make subjective decisions that minimize our potential to be ruined. In those situations, we take preventive actions to avoid harm. We also explore options that are less likely cause harm.
Knowing the difference between risk and uncertainty will help us make better decisions.
Podcast Episode 292—Decision Making: Uncertainty Versus Risk
What is the difference between risk and uncertainty and how our decision-making approach should differ in each scenario. Why pandemics are highly uncertain and should be treated as such.
Topics covered include:
- How the coronavirus pandemic is far worse than other pandemics this century.
- How humans have a difficult time accepting that things won’t return to normal.
- What is the difference between risk and uncertainty.
- How we make decisions should differ if something is uncertain versus risky.
- What is the minimax regret approach to making decisions under uncertainty.
- How stories help us deal with uncertainty.
- How the story driving financial markets has changed.
- What is the duration and severity of bear markets during a recession and how large have bear market stock rallies been.
- What will it take for the pandemic to end and to be more confident about the future.
Forecasting COVID-19 impact on hospital bed-days, ICU-days, ventilator-days and deaths by US state in the next 4 months by IHME COVID-19 health service utilization forecasting team—Institute for Health Metrics and Evaluation
Learn more about uncertainty and risk
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 293. It’s titled, “Making Decisions: Uncertainty Vs. Risk.”
The torn social fabric
We have been sheltered in place here in Phoenix for over 2 weeks now. There are 5 of us. We’ve spent a lot of time walking the dog, taking hikes, doing our best to stay at least 6 feet away from strangers. I’ve only gone to the store once, to the grocery store, about 10 days ago. Most of our food is now delivered. I’ve spent a lot of time reading. Two kids spending a lot of time taking online classes for college. We make dinner together and occasionally watch a movie.
Life, admittedly, is much easier for me than for many of you who have young children at home and you’re trying to, at the same, homeschool them, or help them with school, and pursue your professional activities.
I like this description by Masha Gessen in the New Yorker. She wrote, “The social fabric is being torn in unprecedented ways owing to school closings, a widespread shift to working from home, social distancing, sheltering in place. Whereas we used to share dozens of experiences a day with friends, acquaintances, and strangers from riding the subway, to working in an office, standing in line at lunch, going to a concert, eating at a restaurant, chatting to an Uber driver. Many of us have been reduced to sharing only isolation and the fear of chance encounters. If either of those can be said to be shared.”
The impact today
In early February, episode 286 of the podcast, we looked at the coronavirus and the financial impact of pandemics. At the time I said we didn’t know how severe this would be from a health standpoint because epidemiologists and other health officials were still trying to determine how deadly the virus was, how contagious, how it spreads, and what treatment mechanisms work the best. In some regards, they’re still uncertain.
I was hopeful on the financial and economic fronts that the permanent impact would be minimal and the recovery quick. I mentioned the Federal Reserve had never cut interest rates in response to a pandemic.
At the time there were 27,000 confirmed cases of COVID-19. The vast majority in China. Now there are over 800,000 cases, according to data from John Hopkins University, most outside of China. There have been over 38,000 deaths. In the month of March alone U.S. cases have gone from 98, just 2 digits 9,8, to 164,000. Germany from 159 confirmed to 67,000. Italy from 2,000 to 102,000.
The number of cases and deaths have far exceeded the SARS virus in 2003, MERS in 2012, Ebola in 2014, and the Zika virus in 2015. The number of cases is much less than the H1N1 influenza virus from 2009, commonly known as the swine flu. That virus, there were 61 million cases in the U.S. alone, 12,000 deaths. The mortality rate was only 0.02% whereas the mortality rate globally for confirmed cases of COVID-19 is 4.8%. In the U.S. it’s about 1.9%. Now there’s still a lot of uncertainty about what the final mortality percentage will be.
In China, COVID-19 confirmed cases went from 80,000 to 82,000 in March. The number of cases is probably underreported. But if there was a large-scale outbreak in China, a 2nd wave, the world would know. It would show up in the real-time data you see in China, in terms of percent or energy usage, traffic, the use of public transportation, all of which are down significantly but have been improving, which suggests that hopefully the coronavirus is contained in that country.
In the U.S. the Trump administration has extended social distancing guidelines until the end of April. There’s controversy regarding if there are there enough tests or enough ventilators and masks. Whether we should be wearing masks or not. This is our new reality. In the midst of this new reality, there are a couple of anecdotes that keep coming to mind
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David Stein is the founder of Money For the Rest of Us. Since 2014, he has produced and hosted the Money For the Rest of Us investing podcast. The podcast reaches tens of thousands of listeners per episode and has been nominated for six Plutus Awards. David also leads Money for the Rest of Us Plus, a premium investment education platform that provides professional-grade portfolio tools and training to help individual investors manage their own investment portfolios. He is the author of Money for the Rest of Us: 10 Questions to Master Successful Investing, which was published by McGraw-Hill. Previously, David spent over a decade as an institutional investment advisor and portfolio manager. He was a managing partner at FEG Investment Advisors, a $15 billion investment advisory firm. At FEG, David served as Chief Investment Strategist and Chief Portfolio Strategist.