Everyone has gone through situations that require you to make hard decisions. Sometimes you know what the possible outcomes of your action will be. Other times you do not know what your actions will result in. The first situation in which you know of the possible outcomes is risk and the second situation in which you do not know have any knowledge about the outcome is uncertainty.
This article will explore the two concepts and their types. It also explains how they differ from each other.
Risk vs Uncertainty
A risk is a situation in which you do not know if you will gain something or lose something. You do not know what the outcome of your decisions and actions will be. However, you are aware of the different possible outcomes that can happen. The causes of risk are both factors internal to an individual or company and factors external to an individual. Individuals can necessary precautions to prepare themselves against risks. They can control the effects of risk to an extent. Risk is a quantifiable measure. You can calculate the amount of risk an action will have. Risk has two classifications, systematic risk and unsystematic risk.
Uncertainty is a situation in which you do not know anything about the current situation. You do not know if you will win or if you will lose, or even if those are the two options available. You are not aware of the possible outcomes that can happen. Uncertainty is completely unpredictable. In addition, it is unavoidable. The only thing a person can do is make a decision that can minimize the negative effects and possible future regret. People cannot control an uncertain situation from happening. Uncertainty is immeasurable. Uncertainty has two components, variability and limited knowledge.
Difference Between Risk and Uncertainty in Tabular Form
|Parameters of Comparison||Risk||Uncertainty|
|Meaning||A situation in which you are likely to either win or lose something||A situation in which you are unaware of the future events|
|Quantifiability||Risk can be measured||Uncertainty cannot be measured|
|Knowledge of outcomes||Even though you don’t know which outcome will happen, you are aware of all the possible outcomes that could happen||You are not aware of the possible outcomes|
|Controllability||You can control risk||You cannot control uncertainty|
|Probabilities||Assigned||Probability is not assigned|
|Knowledge of variables||Aware of possible outcomes and probabilities||No knowledge of outcomes or probabilities|
What is Risk?
Sometimes when making new decisions of importance, people tend to make a pros and cons list. When making a pros and cons list you are weighing the benefits of an action against its drawbacks. In a way, you are conducting is risk assessment, analysing the risk of the action or decision. A risk is a situation where an action or decision you make can lead to a win or loss, but you are not aware if it will lead to a win or a loss. When there is a greater potential to experience loss, we call it risk.
A situation with risk can happen because of factors external to the individual like environmental factors or it can be because of factors internal to the individual.
In normal situations, one can prevent or minimise the effect of risky situations by taking necessary precautions.
Different types of risk
The two major kinds of risk are systematic risk and unsystematic risk.
Systematic risks are characteristic of markets. They affect the entire market and not a few businesses. Other names of systematic risk are undiversifiable risk, market risk, and volatility risk. Systematic risk possesses enormous negative outcomes.
One cannot predict or avoid systematic risks. They are completely unpredictable. Some examples of systematic risk are Interest risk, Inflation risk, Market risk, Socio-political risk, and Currency risk.
While it is not possible to avoid systematic risk, one can try to limit their damaging effects on investments. Two strategies to limit the effects of systematic risk are hedging and asset allocation.
Hedging: A method to protect one’s financial assets. Investors hedge one investment by investing the rest of their money in another investment.
Asset allocation: To prepare themselves for unsystematic risk, investors can invest in a variety of asset classes. Instead of putting all their money into one market, they should divide it and invest in a variety of markets. Investors can put some money in a fixed-income account, save some as cash, and invest the rest in real estate and stocks.
Some kinds of risks only apply to specific situations or industries. This type of risk is an unsystematic risk. Unsystematic risk has other names, non-systematic risk, specific risk, residual risk and diversifiable risk.
Systematic risks can occur because of
- An unexpected change in the management of the company
- A company that has so far dominated a specific market suddenly gets a competitor.
- Unsystematic risks can also occur due to situations like product recall, regulatory changes, etc.
- Strikes can cause unsystematic risk to a company
- Natural disasters can bring about unsystematic risks
- Negative outcomes from legal proceedings can lead to unsystematic risks.
Some examples of unsystematic risk are,
Internal issues in a company and external issues from the world can bring about business risk. An example of an internal factor is a situation in which the company's management fails to take out the necessary patent needed for manufacturing a new product. An example of an external factor is when an outside institution bans your product.
Financial risk happens when a company has a weak capital structure. All companies need to maintain the optimal amount of debt and equity. When a company has a weak capital structure it can affect the amount of revenue brought in by the company.
Unexpected events such as a sudden breakdown in a company’s supply chain, a security breach, or an employee overlooking an error in the manufacturing process can lead to operational risks.
Companies need to evolve with the changing world. They need to introduce products according to the current trends. When companies fail to keep up with the developing world, it faces strategic risk.
Legal and regulatory risk
Laws and regulations in a country are susceptible to changes. When such changes in laws and regulations affect the business world, it is a legal and regulatory risk. For example, some countries may legally ban your products.
What is Uncertainty?
Sometimes you may have trouble making decisions or you may refuse to take a certain action because you do not know where it will lead. This situation is uncertain. A situation in which you do not know what the future holds. You will have multiple options and they will all lead to a specific outcome, but you do not know if the outcome will happen.
Since people do not have foreknowledge about uncertainty, they cannot prepare for it. The only thing to do is to make calculated decisions. Leonard Jimmy Savage was a behavioural economist in the 1950s. He introduced a method for making decisions in situations of uncertainty called “minimax regret”. The concept is to take action to minimize the maximum regret that a person can experience.
One example of uncertainty is the recent case of COVID-19. The entire situation was unpredictable ad people did not have any means to prepare for the event. The only option available was to take the decision, which can minimise the negative effects and regret.
Components of uncertainty
While most uncertain situations cannot turn into risks, there are a few that can turn into risks. Whether or they can be turned depends on the following components.
If an uncertain situation is variable, one can eventually convert it into risk by gaining more knowledge about the situation.
Some sources of variability are,
- Inherent randomness
- Value diversity
- Human behaviour
- Social factors
- Technological factors
When there is no knowledge about the uncertain situation, there is no possibility to turn it into a risk. The only way to reduce the uncertainty of the situation is to use exact measurements and collect more data about the situation. In highly complex situations, you can reduce uncertainty by taking the help of technical experts.
Some examples of limited knowledge are,
- Lack of data
- Practical immeasurability
- Conflicting evidence
- Reducible ignorance
- Irreducible ignorance
Risk and Uncertainty According to Different Fields
Different fields of study have different takes on the meaning of risk. Fields like economics, psychology and neurobiology have researched the concepts.
Economics on risk and uncertainty
Sensitivity to likelihood information
People prefer choices about which they know. In the case of risk and uncertainty, people have less information in situations of uncertainty compared to risk. The less information people have about available choices, the less likely they can differentiate between the two. If people cannot differentiate between two choices, they cannot make a decision. In cases of risk, people are aware one choice may lead to a win and the other will lead to a loss. Hence, when faced with a choice between risky situations and uncertain situations, people are more likely to choose risky situations.
Individuals prefer to choose from known choices rather than unknown choices. In ambiguity aversion, individuals display an aversion towards unknown situations rather than known situations. For example, an individual has to choose between two choices. First, the individual will receive a bag filled with apples and oranges in equal quantities. If he can pick an apple out of the bag, he wins. In the second choice, the individual receives a bag filled with some kind of fruit. It can be apples, oranges, mangoes, etc or all of them together. The fruit and their quantity are unknown. Nevertheless, the same rule for winning applies. If the individual can pick an apple from the second bag, he will win. When the individual has to choose between these two choices, there is a much higher probability of picking the first bag filled with apples and oranges in equal quantity. This is because people prefer known choices to unknown choices.
Psychology on risk and uncertainty
Cortisol is a kind of stress hormone. The human body releases Cortisol when faced with stressful situations. The increased levels of cortisol hormone affect decision-making when the individual is in a risk situation. Cortisol hormone does not affect the decision-making processes of uncertain situations.
Decision-making capabilities in situations of uncertainty are impaired in individuals suffering from certain neuropsychological diseases. Some neuropsychological problems where decision-making is impaired are, unilateral lobotomy surgery, obsessive-compulsive problems, gambling addictions, patients with pathological buying problems, and breast cancer patients taking adjuvant chemotherapy. In all these cases, the decision-making for uncertainty is affected, but the decision-making for risk remains unaffected.
Patients with Parkinson's disease have impaired executive functioning. Hence, they are more able to make decisions when faced with uncertainty than risk. This choice is because decision-making processes during risky situations are more dependent on executive functions.
Neurobiology on risk and uncertainty
- According to neurobiological studies, the human brain codes risk and uncertainty differently. The brain regions that deal with risk situations are the orbitofrontal cortex, insula, posterior parietal cortex, and striatum. The brain regions responsible for dealing with uncertainty are the amygdala, inferior frontal gyrus, and the lateral prefrontal cortex.
- Sometimes both risk and uncertainty employ the same brain functions. However, they use them to different degrees. Some areas respond strongly to uncertain situations, while other areas respond strongly to risky situations. For example, the orbitofrontal cortex and amygdala have positive correlations with levels of uncertainty. That is, as the level of uncertainty in a choice increases, the functions of the orbitofrontal cortex and amygdala increase. Alternatively, uncertainty has a negative correlation with the striatal system. That is, as the level of uncertainty increases, the involvement of the striate system decreases.
Main Differences between Risk and Uncertainty (in Points)
- A situation in which you are likely to gain or lose something but are not aware which one will happen is a risk. A situation in which you do not know the choices and outcomes is uncertainty.
- Risk is a measurable concept. In contrast, uncertainty is immeasurable.
- In situations of risk, you are aware of the possible outcomes but you do not know which one will happen. In uncertainty, you are not aware of the possible outcomes.
- People can control risks to a certain extent. People cannot control or predict an instance of uncertainty.
- One can assign probabilities in risk but cannot in uncertainty.
In short, risk and uncertainty are situations in which an individual has some hard-to-make choices. In risky situations, you may not know the outcome of your decision, but you do know all the possible outcomes. In uncertainty, you do not have sufficient information about the situation or its possible outcomes.