The Difference Between Risk and Uncertainty

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Leesbro63
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The Difference Between Risk and Uncertainty

Post by Leesbro63 » Sun Sep 17, 2017 5:35 pm

What is the difference between risk and uncertainty? I heard a discussion about this on a non-financial topic and it made me wonder about this as applied to finance and investing. I guess I always assumed they are the same. But perhaps not.

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Re: The Difference Between Risk and Uncertainty

Post by willthrill81 » Sun Sep 17, 2017 5:42 pm

Far too many, IMHO, equate volatility with risk, which I believe are quite different. For instance, if I have a high degree of confidence that a long-term investment will earn an approximate rate of return, volatility between the time of investment and the time I need the money is irrelevant.

Conversely, I believe nominal bonds, which have a fairly high degree of certainty, to be somewhat risky in real terms. Historically, there's a significant probability that bonds held longer than 20 years will fall behind inflation, resulting in a zero or even negative net return.
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Re: The Difference Between Risk and Uncertainty

Post by lack_ey » Sun Sep 17, 2017 5:49 pm

Risk in most contexts is a potential negative outcome, or the likelihood of such an outcome, with the context telling you which is meant. In some more technical settings, it may be more the product (multiplication) between likelihood of bad outcomes and the effect of them.

Uncertainty is not knowing which outcomes will occur, with greater uncertainty meaning a larger gap between outcomes (weighted by probability).

If there are no possible negative outcomes then you can have high uncertainty without a lot of risk, depending on how you look at things. When talking about financial instruments, this doesn't really exist. That said, in some contexts I think you can reasonably say that potential positive but significantly lower than expected outcomes might be said to be a risk because you're planning on a range of possibilities, most of which are closer to the average or better. Though in a sense that is negative relative to expectations, even if you're making money.

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Re: The Difference Between Risk and Uncertainty

Post by Doc » Sun Sep 17, 2017 6:00 pm

lack_ey wrote:
Sun Sep 17, 2017 5:49 pm
Risk in most contexts is a potential negative outcome, ...
That's where the problem lies. Investers think of risk as losing money. But statistictions this of risk in terms of standard deviation which is both plus and minus. We all need to keep the distinction in mind.
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Re: The Difference Between Risk and Uncertainty

Post by willthrill81 » Sun Sep 17, 2017 6:03 pm

Doc wrote:
Sun Sep 17, 2017 6:00 pm
lack_ey wrote:
Sun Sep 17, 2017 5:49 pm
Risk in most contexts is a potential negative outcome, ...
That's where the problem lies. Investers think of risk as losing money. But statistictions this of risk in terms of standard deviation which is both plus and minus. We all need to keep the distinction in mind.
Precisely. For instance, the historical volatility of stock returns does not decrease with time invested, but the likelihood of losing money has absolutely decreased with time invested.
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Re: The Difference Between Risk and Uncertainty

Post by alex_686 » Sun Sep 17, 2017 6:03 pm

Risk can be insured against. Thus is can be measured - though often times incorrectly. It is a known unknown.

Uncertainty can not be insured again. It is a unknown unknown.

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Re: The Difference Between Risk and Uncertainty

Post by avalpert » Sun Sep 17, 2017 6:08 pm

The distinction I see most often in Finance and Economics is that Risk is when you don't know the outcome but know the distribution of possible outcomes and Uncertainty is when you don't know the outcome or the distribution of possible outcomes.

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Re: The Difference Between Risk and Uncertainty

Post by arcticpineapplecorp. » Sun Sep 17, 2017 6:12 pm

was this the podcast you heard it? Freakonomics "“How Much Brain Damage Do I Have?” I think it was pretty well explained in the podcast actually (and the transcript at the website below).

http://freakonomics.com/podcast/brain-damage/

The "Lo" below is Andrew Lo of M.I.T.
Now, we all know the conventional wisdom — that the big rewards in life go to the people willing to take big risks, right? Frank Knight saw it a bit differently.

LO: He realized that the way you make a huge amount of money is not to take on risk. The reason is because risk, by his definition, is the kind of randomness that you can quantify. And if you can quantify it, so can everybody else. You can’t really outsmart other people because they can calculate just as well as you can.

So using probability and statistics, you can calculate risk. And because the odds of a given risk can be calculated, that risk can also be priced.

LO: Exactly. A good example is the insurance industry.

So risk is the stuff of actuarial tables. Taking on risk might make you a good living. But it wouldn’t have made you a multi-billionaire. To do that, Frank Knight argued, you had to take on something else entirely: uncertainty.

LO: For example, if you create an entirely new industry that didn’t exist before, there’s no way to calculate what the odds are. When Bill Gates started up Microsoft, we didn’t have a huge PC and software industry. He created that. He couldn’t sit down and calculate what the odds [were]. Knight came up with this idea that the way you really make money, the way innovation really occurs in the economy, is through taking on uncertainty, not taking on risk. source: http://freakonomics.com/podcast/brain-damage/
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Re: The Difference Between Risk and Uncertainty

Post by longinvest » Sun Sep 17, 2017 6:36 pm

So far, the best definition of risk that I have read is the one given by Zvi Bodie in his book Risk Less and Prosper. The definition itself is short:
In Risk Less and Prosper, Zvi Bodie wrote:
Investment risk is uncertainty that matters.
But, to better appreciate the nuances of this definition, here is the context (I underlined the essential part):
In Risk Less and Prosper, Zvi Bodie wrote:
A few proposed definitions of risk that commonly surface include: the unknown; the chance that something harmful may happen; uncertain outcomes that may cause loss; and uncertainty that arouses fear.

Let’s discard the idea that risk is nothing but the unknown, because risk is more than the ordinary uncertainty that surrounds our lives. By referring to harm, loss, and fear, the next three suggestions reflect one fundamental property of risk: Somebody has to care about the consequences if uncertainty is to be understood as risk.

The notion of “caring” or “mattering” is central. It captures both the potential (objective) impact of uncertainty as well as its (subjective) bite. This brings us close to the definition we’ll adopt: Investment risk is uncertainty that matters. There are two prongs to this definition—the uncertainty, and what matters about it—and both are significant.

So, beyond the odds of hitting a rough patch, there are the consequences of loss to consider.
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Re: The Difference Between Risk and Uncertainty

Post by William4u » Sun Sep 17, 2017 6:50 pm

There is a huge lit on this, but the simplest version is this...

1. Risk is the (often roughly) known probability of a known outcome. So a 50% chance of losing $100 is a risk of a negative outcome. Sometimes this is put it terms of expected utility or decision theory.

2. Uncertainty is when the probability is unknown and/or the outcome is unknown.

These are simplifications, but a good place to start.

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Re: The Difference Between Risk and Uncertainty

Post by nisiprius » Sun Sep 17, 2017 6:58 pm

William4u wrote:
Sun Sep 17, 2017 6:50 pm
There is a huge lit on this, but the simplest version is this...

1. Risk is the (often roughly) known probability of a known outcome. So a 50% chance of losing $100 is a risk of a negative outcome. Sometimes this is put it terms of expected utility or decision theory.

2. Uncertainty is when the probability is unknown and/or the outcome is unknown.

These are simplifications, but a good place to start.
That's pretty much the Knightian definition. Unfortunately, I've discovered that his definitions are not by any means widely accepted. The funny thing is that in common parlance, the use is often the reverse of Knight's.

Also, we do have to be cognizant of the fact that "risk" seems to have a widely accepted, perfectly good definition in financial economics: it is simply used to mean "standard deviation." To object to that is to object to a physicist using "power" to mean "energy per unit of time," rather than "authority," "military strength," or "the sixth of the nine orders of angels."
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Re: The Difference Between Risk and Uncertainty

Post by dbr » Sun Sep 17, 2017 7:06 pm

This kind of question does not have a short and definitive answer. To a great extent the actual answer is you give me your definition of risk and your definition of uncertainty and you will have answered your own question.

In investing risk is conventionally defined as the variability of (annual) returns, measured by standard deviation of annual returns. In most discussions mention of this fact is followed by comments of all kinds that there are many other or different ideas of what risk could be. All of those suggestions are correct and some of them are even very important. None of those comments change the facts regarding what the conventional meaning is, if that is what you want to know.

Uncertainty is a very general idea. You could parse nuances all day long about whether or in what way risk in general and uncertainty in general may be compared (finding ways they are the same) and contrasted (finding ways they are different). However, the conventional notion of risk in investing, the standard deviation of annual returns, can be connected to one concept of uncertainty in a very basic way. The picture is that the return in a given year will be a random sample from a distribution of possible returns. What possibilities that distribution ranges over is a definition of uncertainty. Uncertainty is expressed as the relative chances of getting any particular result. A specific illustration might be a statement like "There is a 90% chance the return will fall between 5% and 7%." That is more uncertain than "There is a 99% chance the return will be between 5.9% and 6.1%." and less uncertain than "There is a 50% chance the return will fall between 3% and 9%."

If people want to have different ideas of uncertainty and even of risk, there is nothing wrong with that. How helpful it is depends on what you wanted to know in the first place.

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Re: The Difference Between Risk and Uncertainty

Post by Fallible » Sun Sep 17, 2017 7:10 pm

An excellent explanation of risk and uncertainty and their differences comes from Ben Carlson in his book, A Wealth of Common Sense, beginning pg. 52 on "Risk versus Uncertainty":
Risk is defined as the exposure to the chance of injury or loss. At times it can feel like you become injured when you lose money, so this is an apt definition. Uncertainty, on the other hand, is an unforseeable event or outcome. It's easy for investors to confuse risk and uncertainty, but you have to be aware of the fact that things are always uncertain. They just feel more certain when markets are rising and more uncertain when they're falling.
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Re: The Difference Between Risk and Uncertainty

Post by bobcat2 » Sun Sep 17, 2017 7:43 pm

In finance and economics risk is uncertainty that matters.

You and I flip a coin 100 times. I get a penny for every head and you get a penny for every tail. There is uncertainty about who will come out ahead, but there is no financial risk.

Same game, but now $5,000/flip. Same amount of uncertainty, but now there is financial risk.

Uncertainty simply means the outcome is not certain. Risk in finance means an uncertain outcome is nontrivial for at least some of the people subject to the uncertainty.

See my signature below for a succinct statement on this point.

BobK

PS - I see longinvest made the same point in an above post.
longinvest wrote:
Sun Sep 17, 2017 6:36 pm
So far, the best definition of risk that I have read is the one given by Zvi Bodie in his book Risk Less and Prosper. The definition itself is short:
In Risk Less and Prosper, Zvi Bodie wrote:
Investment risk is uncertainty that matters.
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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Re: The Difference Between Risk and Uncertainty

Post by Copernicus » Sun Sep 17, 2017 7:53 pm

Uncertainty has only one definition, whereas, risk is defined differently depending on the context. Investment returns are uncertain. The more uncertain the outcome the more risky the venture.
Some may simply define risk as the possibility of a loss of investment value. When markets reach new highs, and the markets are called “risky”.

Another definition:
Investors have different goals in financial investments, e.g., saving for retirement, saving for a major purchase, saving for early retirement, long-term capital appreciation, saving towards kids’ education, etc.
Probability that one will fail to reach a desired outcome. The greater the chances of failure the greater the risk.
Different investors have different needs for liquidity. The same investment may appear more or less risky depending the individual need for liquidity. If the desired outcome is accumulating enough money to retire at a certain age, with a specific post-retirement income, ‘safer’ investments may fail to build sufficient wealth. An investor might outlive the investment portfolio. This is an example of "shortfall risk." Therefore, in financial planning, the investment goal must be considered in defining risk.  

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Re: The Difference Between Risk and Uncertainty

Post by bogglizer » Sun Sep 17, 2017 8:34 pm

From a mathematical perspective, risk almost always includes the upside as well as the downside. This is because when only considering the downside, it is almost impossible to compute anything.

Even unknown unknowns have probability distributions. These are, for example, the long tails of stock volatility distributions.

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Re: The Difference Between Risk and Uncertainty

Post by qwertyjazz » Sun Sep 17, 2017 8:57 pm

nisiprius wrote:
Sun Sep 17, 2017 6:58 pm
William4u wrote:
Sun Sep 17, 2017 6:50 pm
There is a huge lit on this, but the simplest version is this...

1. Risk is the (often roughly) known probability of a known outcome. So a 50% chance of losing $100 is a risk of a negative outcome. Sometimes this is put it terms of expected utility or decision theory.

2. Uncertainty is when the probability is unknown and/or the outcome is unknown.

These are simplifications, but a good place to start.
That's pretty much the Knightian definition. Unfortunately, I've discovered that his definitions are not by any means widely accepted. The funny thing is that in common parlance, the use is often the reverse of Knight's.

Also, we do have to be cognizant of the fact that "risk" seems to have a widely accepted, perfectly good definition in financial economics: it is simply used to mean "standard deviation." To object to that is to object to a physicist using "power" to mean "energy per unit of time," rather than "authority," "military strength," or "the sixth of the nine orders of angels."
That would imply that Knight was not a financial economist. His definitions of types of risk and uncertainty were grounded in a discussion of finance per my recollection. He also has been referenced by multiple more modern 'financial economists' I think there are a family of classic models where risk is the sd of the outcome. But the uniformity I think is more the result of textbook synthesis rather than a true uniformity of opinion.
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Re: The Difference Between Risk and Uncertainty

Post by willthrill81 » Sun Sep 17, 2017 8:57 pm

bogglizer wrote:
Sun Sep 17, 2017 8:34 pm
From a mathematical perspective, risk almost always includes the upside as well as the downside. This is because when only considering the downside, it is almost impossible to compute anything.

Even unknown unknowns have probability distributions. These are, for example, the long tails of stock volatility distributions.
That's why standard deviation is a poor measure of risk; it captures 'upside' volatility as well as downside. If an investment is making a jumpy run upwards, I couldn't care less about the standard deviation.
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Re: The Difference Between Risk and Uncertainty

Post by pkcrafter » Sun Sep 17, 2017 11:54 pm

Ritholtz/Mauboussin on risk and uncertainty:

http://ritholtz.com/2012/12/defining-ri ... ncertainty:


Travis Morien: Risk is not having the money when you need it to buy something important



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When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Re: The Difference Between Risk and Uncertainty

Post by snackdog » Mon Sep 18, 2017 5:24 am

A risk is something bad potentially happening. An uncertainty is something you don't know.

Uncertainties
- I am uncertain (don't know) if it will rain tomorrow.
- I am uncertain how the stock market will perform.
- I don't know if my house is strong enough to withstand a hurricane.

Risks
- If it does rain and I don't have my umbrella, I will get wet.
- If the stock market collapses, I panic and sell all my shares, I will lose money.
- If hurricane winds strike my house and it is not strong enough, it will be damaged.

There are even risks which have uncertain consequences, e.g.
-If hurricane winds strike my house of straw, it may blow away entirely or just lose the roof.

There are risks in investing (chances of the outcome not meeting the expectation) because market performance is uncertain (can not be known).

and don't forget mitigations, which are things we do to limit the damage in the event bad things happen -

Mitigations
-If I forget my umbrella, I can probably borrow one or take refuge somewhere so I don't get wet.
-If the market collapses, maybe my bond and gold holdings will surge and reduce my losses.
-If the hurricane obliterates my house, my insurer may pay for a brand new one.

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Re: The Difference Between Risk and Uncertainty

Post by nisiprius » Mon Sep 18, 2017 5:50 am

qwertyjazz wrote:
Sun Sep 17, 2017 8:57 pm
nisiprius wrote:
Sun Sep 17, 2017 6:58 pm
William4u wrote:
Sun Sep 17, 2017 6:50 pm
...1. Risk is the (often roughly) known probability of a known outcome. 2. Uncertainty is when the probability is unknown and/or the outcome is unknown.
Those are pretty much Knight's definitions. Unfortunately, I've discovered that his definitions are not by any means widely accepted. The funny thing is that in common parlance, the use is often the reverse of Knight's. Also, we do have to be cognizant of the fact that "risk" seems to have a widely accepted, perfectly good definition in financial economics: it is simply used to mean "standard deviation." To object to that is to object to a physicist using "power" to mean "energy per unit of time," rather than "authority," "military strength," or "the sixth of the nine orders of angels."
That would imply that Knight was not a financial economist. His definitions of types of risk and uncertainty were grounded in a discussion of finance per my recollection. He also has been referenced by multiple more modern 'financial economists' I think there are a family of classic models where risk is the sd of the outcome. But the uniformity I think is more the result of textbook synthesis rather than a true uniformity of opinion.
Well, let's put it this way. I was told pretty definitely by bobcat2, who is a financial economist, that Knight's definitions are not used nowadays in financial economics.

I've tried Google searches and dictionaries, and the conclusion I've come to is that risk and uncertainty are fraught terms and no, there are not any consensus definitions. Of course, it's made worse by the way people with things to sell use rhetorical manipulation. Since most people feel risk is bad, anyone selling risky assets likes to spin the term "risk" so that whatever they are promoting is not risky if you view risk in the "right" way:
In his novel, 'The Way of All Flesh' written in the early 1880s, Samuel Butler wrote:How often do I not hear middle-aged women and quiet family men say that they have no speculative tendency; they never had touched, and never would touch, any but the very soundest, best reputed investments, and as for unlimited liability, oh dear! dear! and they throw up their hands and eyes.

Whenever a person is heard to talk thus he may be recognised as the easy prey of the first adventurer who comes across him; he will commonly, indeed, wind up his discourse by saying that in spite of all his natural caution, and his well knowing how foolish speculation is, yet there are some investments which are called speculative but in reality are not so, and he will pull out of his pocket the prospectus of a Cornish gold mine.
Last edited by nisiprius on Mon Sep 18, 2017 6:03 am, edited 1 time in total.
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Re: The Difference Between Risk and Uncertainty

Post by nisiprius » Mon Sep 18, 2017 5:59 am

It's a zoo. Consider, for example, an actual textbook: Investments, 7th edition, Bodie, Kane, and Marcus. I go to the glossary. I look up the word "risk."

It's not there.

I do, however, find definitions for ten or so terms: risk arbitrage, risk-averse, risk-neutral, risk lover, risk-neutral, risk premium, risk-return trade-off, risky asset. All of these terms simply assume that we know what risk means; for example, "risk-return trade-off" is defined as "If an investor is willing to take on risk, there is the reward of higher expected returns."

Only two of these definitions even suggest a meaning for risk:
Bodie, Kane, and Marcus, in their textbook wrote:Risk-free asset: An asset with a certain rate of return. Often taken to be short-term T-bills.
Risky asset: An asset with an uncertain rate of return.
So, here, "risk" and "uncertainty" are basically being treated as close synonyms.

Based on those two short definitions, I get the impression that these authors definitely regard "risk" as bidirectional; it is uncertainty either way.

Paging through some of the index references to risk, it seems to me that the authors just use the word in a fairly casual say, as if everyone knew what risk was--as if there's no point in trying to define the word risk, only specific narrow technical kinds of risk.
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Re: The Difference Between Risk and Uncertainty

Post by nisiprius » Mon Sep 18, 2017 6:08 am

One final observation. If the words "risk" and "uncertainty" were generally understood to have the meanings Knight gave them, there would be no need for Nassim Nicholas Taleb to have coined the phrase "black swans." His "black swans" would just be "uncertainty." I understand that Uncertainty might not have been as good a title as The Black Swan, but, still.

I don't believe you could simply use the word "uncertainty," without explanation, to mean "financial variables whose underlying statistical distributions are unknown, as distinct from those whose underlying statistical distributions are known" and expect people to understand you.
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Re: The Difference Between Risk and Uncertainty

Post by Seasonal » Mon Sep 18, 2017 6:57 am

nisiprius wrote:
Sun Sep 17, 2017 6:58 pm
Also, we do have to be cognizant of the fact that "risk" seems to have a widely accepted, perfectly good definition in financial economics: it is simply used to mean "standard deviation." To object to that is to object to a physicist using "power" to mean "energy per unit of time," rather than "authority," "military strength," or "the sixth of the nine orders of angels."
Standard deviation may be widely used as a measure of risk, but I don't believe it is the definition of risk.

There are many measures, such as beta, standard deviation, the Sharpe ratio and the Fama-French risk factors.

Sharpe sometimes says risk is the probability of not having sufficient resources when you need them. To me, this tracks what people mean by risk in this context.

I'd also note that arguing definitions seldom satisfies anyone. I find Knight's distinction (the odds v. not knowing the odds) useful, but rather than trying to get people to agree on definitions, I think it would be more productive to discuss how to apply the concepts. For example, one might say stocks are risky in part because we don't know what the distribution of returns will be in the future. This seems better than saying stocks are risky because they have had a high standard deviation, then getting into an argument over whether SD exactly equals risk. YMMV.

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Re: The Difference Between Risk and Uncertainty

Post by avalpert » Mon Sep 18, 2017 7:23 am

nisiprius wrote:
Mon Sep 18, 2017 6:08 am
One final observation. If the words "risk" and "uncertainty" were generally understood to have the meanings Knight gave them, there would be no need for Nassim Nicholas Taleb to have coined the phrase "black swans." His "black swans" would just be "uncertainty." I understand that Uncertainty might not have been as good a title as The Black Swan, but, still.
I actually disagree with this in a way that might illuminate some of the distinction. If you use the 'black swan' in the oversold, generic way that it has been used since 2009 then I agree - but in Taleb's meaning Black Swan's aren't just uncertain (in that we don't know their statistical distribution)- they are inconceivable (in that we can't even articulate what it is we are trying to devise a statistical distribution for).

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Re: The Difference Between Risk and Uncertainty

Post by qwertyjazz » Mon Sep 18, 2017 7:25 am

nisiprius wrote:
Mon Sep 18, 2017 5:50 am
qwertyjazz wrote:
Sun Sep 17, 2017 8:57 pm
nisiprius wrote:
Sun Sep 17, 2017 6:58 pm
William4u wrote:
Sun Sep 17, 2017 6:50 pm
...1. Risk is the (often roughly) known probability of a known outcome. 2. Uncertainty is when the probability is unknown and/or the outcome is unknown.
Those are pretty much Knight's definitions. Unfortunately, I've discovered that his definitions are not by any means widely accepted. The funny thing is that in common parlance, the use is often the reverse of Knight's. Also, we do have to be cognizant of the fact that "risk" seems to have a widely accepted, perfectly good definition in financial economics: it is simply used to mean "standard deviation." To object to that is to object to a physicist using "power" to mean "energy per unit of time," rather than "authority," "military strength," or "the sixth of the nine orders of angels."
That would imply that Knight was not a financial economist. His definitions of types of risk and uncertainty were grounded in a discussion of finance per my recollection. He also has been referenced by multiple more modern 'financial economists' I think there are a family of classic models where risk is the sd of the outcome. But the uniformity I think is more the result of textbook synthesis rather than a true uniformity of opinion.
Well, let's put it this way. I was told pretty definitely by bobcat2, who is a financial economist, that Knight's definitions are not used nowadays in financial economics.

I've tried Google searches and dictionaries, and the conclusion I've come to is that risk and uncertainty are fraught terms and no, there are not any consensus definitions. Of course, it's made worse by the way people with things to sell use rhetorical manipulation. Since most people feel risk is bad, anyone selling risky assets likes to spin the term "risk" so that whatever they are promoting is not risky if you view risk in the "right" way:
In his novel, 'The Way of All Flesh' written in the early 1880s, Samuel Butler wrote:How often do I not hear middle-aged women and quiet family men say that they have no speculative tendency; they never had touched, and never would touch, any but the very soundest, best reputed investments, and as for unlimited liability, oh dear! dear! and they throw up their hands and eyes.

Whenever a person is heard to talk thus he may be recognised as the easy prey of the first adventurer who comes across him; he will commonly, indeed, wind up his discourse by saying that in spite of all his natural caution, and his well knowing how foolish speculation is, yet there are some investments which are called speculative but in reality are not so, and he will pull out of his pocket the prospectus of a Cornish gold mine.
FWIW Caballero is a financial economist at MIT
https://www.minneapolisfed.org/publicat ... -caballero

So the proof of no black swans is easy to refute - but how common and in what way is Knight still used is far more complex. I like your term 'zoo' to describe our understanding of risk and uncertainty. I think there are multiple other definitions as well which add insight but not necvesarily clarity.
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Re: The Difference Between Risk and Uncertainty

Post by dbr » Mon Sep 18, 2017 9:27 am

Seasonal wrote:
Mon Sep 18, 2017 6:57 am

I'd also note that arguing definitions seldom satisfies anyone. I find Knight's distinction (the odds v. not knowing the odds) useful, but rather than trying to get people to agree on definitions, I think it would be more productive to discuss how to apply the concepts. For example, one might say stocks are risky in part because we don't know what the distribution of returns will be in the future. This seems better than saying stocks are risky because they have had a high standard deviation, then getting into an argument over whether SD exactly equals risk. YMMV.
You are absolutely correct that arguing about definitions is pointless. The very nature of definitions is that anyone can make them whatever they want them to be. The only price is whether or not any two people are talking about the same thing.

You are also absolutely correct that the useful thing is finding helpful ways to talk about things. Once a useful concept becomes evident definitions are created to implement that.

The risk as standard deviation definition was created to implement one way of talking about investment returns that is very useful if people let it be. But that concept does not cover everything and may not cover some very important things.

Much of the content in arguing about definitions has to do with wanting to be told what to think instead of thinking.

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Re: The Difference Between Risk and Uncertainty

Post by rnitz » Mon Sep 18, 2017 9:06 pm

I value the economist definition of risk as standard deviation - it has value, it's calculable, you can use it. But it doesn't meet an everyday definition of risk.

I come to your house with a bag of cash. I tell you that I'm going to flip a coin and if it's heads I'll give you $ 10,000 and if it's tails I'll give you $ 1,000,000. To the economist I've drastically increased the risk to your household. To a normal person, he says "Yippee".

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Re: The Difference Between Risk and Uncertainty

Post by OkieIndexer » Mon Sep 18, 2017 9:35 pm

For me, measures of "risk" that incorporate downside volatility (the only volatility we care about, really) like the Sortino and Sharpe Ratios are somewhat useful, but real risk is the risk of running out of money after you've retired and before you die, assuming you're living entirely on your portfolio (plus Social Security). But Social Security alone may not be enough to sustain you if you didn't work enough years, didn't have a high salary, etc., or if they cut Social Security benefits in the future. So that's why running down your portfolio to $0 seems to be the real financial risk of all risks to me.

That's also why sequence-of-returns is so important, too. Your risk of running out of money was a lot higher if you retired in 1929 or 1966 than in 1982 since '29 and '66 were the start of long bad periods for stocks and high inflation (in the 1940s and 70s).

Also, your own "human behavior risk" is very important too. This is the risk that you won't stay the course with your investment plan, but might change your strategy, or panic after a 50% drop in stocks and sell your stocks near the bottom, missing the big gains afterwards, then buy back in near the top of a bull run, which will hugely negatively impact your returns compared to what your investment plan was supposed to get you. Changing strategies often (usually in response to recent market developments) is also a big drag on returns (I know this from personal experience).

Uncertainty is more that you don't know what the future holds in things financial. You don't know if you've retired at a bad time (like '29 or '66) or a good time ('82). You don't know if there will be high inflation going forward. You don't know what will happen with Social Security, Medicare, health care costs/insurance, etc. You don't know how you will react to market downturns, black swans, or other market developments.

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Re: The Difference Between Risk and Uncertainty

Post by Valuethinker » Tue Sep 19, 2017 11:03 am

Leesbro63 wrote:
Sun Sep 17, 2017 5:35 pm
What is the difference between risk and uncertainty? I heard a discussion about this on a non-financial topic and it made me wonder about this as applied to finance and investing. I guess I always assumed they are the same. But perhaps not.
https://en.wikipedia.org/wiki/Knightian_uncertainty

takes us back to Frank Knight.

Uncertainty is what we cannot quantify. Risk is what we can quantify.

However this definition, although widely cited, has not subsequently found much traction in economics. We tend to focus on risk by the textbook definition-- annual volatility in asset returns.

In an actuarial sense, actuarial risk is a failure by assets to meet liabilities eg not enough savings to reach death, comfortably.

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Re: The Difference Between Risk and Uncertainty

Post by Kevin M » Tue Sep 19, 2017 11:57 am

nisiprius wrote:
Mon Sep 18, 2017 5:59 am
It's a zoo. Consider, for example, an actual textbook: Investments, 7th edition, Bodie, Kane, and Marcus. I go to the glossary. I look up the word "risk."

It's not there.
Interesting. I have the third edition, and in the index I see:

Code: Select all

Risk
 defined, 123
On page 123 I see:
Risk means uncertainty about future rates of return. We can quantify that uncertainty using probability distributions.
This definition is consistent with the definitions in my other investing textbooks. For example, in Investment Analysis and Portfolio Management, Fourth Edition, by Frank K. Reilly (page 242):
Although there is a difference in the specific definitions of risk and uncertainty, for our purposes and in most financial literature the two terms are used interchangeably. In fact, one way to define risk is as the uncertainty of future outcomes.
Earlier in the text, page 11, it is stated more succinctly:
Risk is the uncertainty that an investment will earn its expected rate of return.
The textbooks are also consistent in defining standard deviation of returns as a measure of risk, not as risk itself. They also clarify that it's not the only measure of risk, but the one that's used most commonly in investment theory, mostly thanks to Markowitz and the development of MPT.

A related point is that risk is not defined as annual volatility. It is defined as the uncertainty of the rate of return over the holding period of interest, which of course for most of us is much longer than one year. People just happen to use annual returns as a convenient way to measure historical uncertainty of returns, so to the extent we pay attention to this, technically it is applicable only to a one-year holding period. An argument can be made that it is somewhat applicable to longer holding periods because longer-term uncertainty tends to be proportional to shorter-term uncertainty. It's hard to measure the uncertainty of longer term returns due to the limited amount of longer-term independent periods in the historical data.

Kevin
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Re: The Difference Between Risk and Uncertainty

Post by nisiprius » Tue Sep 19, 2017 1:57 pm

Kevin M wrote:
Tue Sep 19, 2017 11:57 am
nisiprius wrote:
Mon Sep 18, 2017 5:59 am
It's a zoo. Consider, for example, an actual textbook: Investments, 7th edition, Bodie, Kane, and Marcus. I go to the glossary. I look up the word "risk."

It's not there.
Interesting. I have the third edition, and in the index I see:

Code: Select all

Risk
 defined, 123
That's sufficiently "interesting" that I really think I'd better reproduce the page in question. I wonder what happened between the 3rd and the 7th edition? By the way, "volatility risk," which I did look up, is not the risk of volatility itself, it's the risk that volatility will change.

Image
The textbooks are also consistent in defining standard deviation of returns as a measure of risk, not as risk itself. They also clarify that it's not the only measure of risk, but the one that's used most commonly in investment theory, mostly thanks to Markowitz and the development of MPT.
I stand corrected and will be more careful in future.
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Re: The Difference Between Risk and Uncertainty

Post by alex_686 » Tue Sep 19, 2017 2:28 pm

I am going to throw in my 2 cents on standard deviation. There is a reason why it is often used to describe risk.

It is both simple and easy. The inputs are observable and objective. It works wells across a wide range of assets and time periods. The methodology is theoretically robust. It works well out to about 3 sigma for daily risk analysis.

And here I will end my defense of standard deviation - 3 sigma. When it fails here it fails big, which is the most common criticism of the approach. There are other ways to measure but they break most of the above points. You tend to get complex bespoke solutions which are not transferable to other situations.

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Re: The Difference Between Risk and Uncertainty

Post by bobcat2 » Tue Sep 19, 2017 2:50 pm

There is a consensus on climate change. There is a consensus on evolution. There is a consensus on the meaning of risk. On each of these subjects there is a small minority of skeptics and deniers, but nonetheless there is consensus on all three of these topics. Here is the consensus on risk. You can disagree with the consensus meaning of risk, but that doesn't mean there isn't a consensus.

Here is the meaning of the word risk from several dictionaries and an encyclopedia. - Pure Risk

The possibility of loss or injury - Merriam-Webster dictionary

The possibility that something unpleasant or unwelcome will happen – Oxford Dictionary

1. A factor, thing, element, or course involving uncertain danger; a hazard.
2. The possibility of suffering harm or loss; danger. – TheFree Dictionary

Risk is the possibility or chance of loss, danger or injury. – YourDictionary

The possibility that something unpleasant or dangerous might happen. – MacMillan Dictionary

The possibility of incurring misfortune or loss. – Collins Dictionary

Risk is the potential of losing something of value. – Wikipedia

Notice that all the above sources are defining pure risk the same way. They are simply using different words in their definitions. The distinction between pure risk and speculative risk is addressed next..


The following is the meaning of risk in finance and economics. - Speculative Risk

Investment risk - The chance that an investment's actual return will be different than expected. – INVESTOPEDIA

Here is the definition of risk from SBBI - the investment bible.
Risk - The extent to which an investment is subject to uncertainty. Risk may be measured by standard deviation. -SBBI 2005 edition


In what follows risk is defined in several leading economics and finance textbooks.

Risk is uncertainty that "matters" because it affects people's welfare. - Merton et al - Financial Economics

The term risk refers to the variability of the outcomes of some uncertain activity. - Nicholson - Microeconomic Theory

Risk is the uncertainty associated with the end-of-period value of an investment in either a single asset or a portfolio of assets.
Sharpe et al - Investments

Risk - the variability (or unpredictability) an asset contributes to a saver's real wealth. - Krugman et al - International Economics

The presence of risk means that more than one outcome is possible. - Bodie et al – Investments

Three of the above definitions come from Nobel Prize winners and two of the Nobel winners (Sharpe and Merton) won for their work in financial economics. Another definition comes from Bodie et al - Investments, the world's best selling MBA level textbook on investments.

Notice that all these sources are defining economic and financial risk the same way. They are simply using different words in their definitions.

We see from the above that there is one substantive caveat to the meaning of risk in that there are two distinct categories of risk – pure risk and speculative risk.

Pure risk involves events where there is loss or no change. There is no chance for gain. Examples are risk of injury, illness, accident, or property damage. People generally do not take pure risk by choice.

Speculative risk OTOH involves situations where either a gain or loss is possible. People usually take speculative risk by choice. Purchasing stocks or buying a lottery ticket are examples of speculative risk. In general investment risks are speculative risks.

The above definitions of risk given by the dictionaries are referring to pure risk. The above definitions of risk in finance are referring to speculative risk.


As an aside - Knightian uncertainty

It almost goes without saying that any discussion of risk at Bogleheads will involve someone invoking the distinction between risk and uncertainty that Frank Knight made roughly 100 years ago, but which has been discarded in mainstream economics and finance for many decades as little more than an interesting philosophical speculation with little practical value. Although it does make a small comeback whenever there is a major financial crisis - the Great Recession of 2008-2009 being a prime example.
Kevin M wrote:
louis c wrote:Now we will consider uncertainty, which has no known distribution of outcomes.
This sometimes is referred to as Knightian uncertainty. I believe Larry Swedroe has written about it more than once. Knight published a book that included a discussion of this in 1921: Risk, uncertainty and profit : Knight, Frank H. (Frank Hyneman), 1885-1972 : Free Download & Streaming : Internet Archive.
Mainstream finance theory seems to have departed from this view, since risk commonly is defined as the uncertainty of return over the holding period of interest.
As you can see from the above definitions of risk mainstream finance and economics has definitely departed from this Knightian view of risk and uncertainty.

For more on risk in finance see this - viewtopic.php?t=83960

and this from the Bogleheads wiki - https://www.bogleheads.org/wiki/Investm ... management

Standard deviation is a way to measure speculative risk. A way to measure something is not the same thing as the definition of that something.

The general definition of risk is not the same thing as any particular risk you are concerned about.

BobK

PS -
The presence of risk means that more than one outcome is possible.
- Bodie et al – Investments 6th edition
The above definition is found on page 166. It is the first sentence in the subsection - Risk and Risk Aversion.

Also in the glossary on page 1057 there is this.
Risky asset. An asset with an uncertain rate of return.
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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Re: The Difference Between Risk and Uncertainty

Post by Kevin M » Tue Sep 19, 2017 3:33 pm

nisiprius wrote:
Tue Sep 19, 2017 1:57 pm
That's sufficiently "interesting" that I really think I'd better reproduce the page in question. I wonder what happened between the 3rd and the 7th edition?
Look in the section on Risk Premiums. In my version, section 4.2 is titled "Risk and Risk Premiums", and the definition I quoted is the first sentence in that section. I actually found it by quickly scanning the book before looking it up in the index (I just assumed I wouldn't find it in the index, based on your observation, so was surprised to find it after finding the definition by scanning).

Kevin
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Re: The Difference Between Risk and Uncertainty

Post by nisiprius » Tue Sep 19, 2017 5:57 pm

I don't think I've seen the term "speculative risk" (as distinct from "risk") before. Is that a generally understood term?

BobK and Kevin, and any other who wish to comment... in the light of the two groups of definitions BobK has marshaled, what would you say about the fairly frequently echoed phrase, "volatility is not risk?"

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Re: The Difference Between Risk and Uncertainty

Post by Kevin M » Tue Sep 19, 2017 6:28 pm

nisiprius wrote:
Tue Sep 19, 2017 5:57 pm
BobK and Kevin, and any other who wish to comment... in the light of the two groups of definitions BobK has marshaled, what would you say about the fairly frequently echoed phrase, "volatility is not risk?"
Answer 1. Because people usually are speaking about short-term uncertainty of returns when they use the term volatility, and long-term investors should be more interested in the long-term uncertainty of returns. You can apply volatility to long-term returns uncertainty as well, but I don't think it's the common usage. Even though I think stocks are risky in the long run, I don't think it's the volatility of annual returns that we should be so concerned about from a purely rational (non-emotional) perspective.

Answer 2. Although there is a large dispersion of probable long-term return outcomes for risky assets like stocks, the expected return is higher than that for less risky assets. People focus more on the expected return than the dispersion of probable returns, so even the higher long-term volatility is less of a concern for them; i.e., there's a larger dispersion around a higher mean.

Also, many people view historical US stock returns as good data for estimating future probability distributions, and they see that long-term outcomes generally have been quite good compared to more frequent short-term bad outcomes (volatility). In other words, they believe that they'll always recover from a bad downturn as long as they have a sufficiently long investment horizon, or that they'll be OK in retirement with a significant allocation to risky assets as long as they keep their withdrawal rate at say 4% or below.

EDIT. And when it's pointed out that we don't have nearly enough independent 30-year returns to come up with any reliable probability distributions of 30-year returns, they argue that it's OK to use rolling 30-year periods in such analyses (better yet, let's use rolling monthly returns to get even more samples :oops:). The people with strong statistical backgrounds that used to dispute the validity of using rolling returns for this type of analysis don't seem to post here anymore--at least not in the threads on this I've participated in lately.

Kevin
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Re: The Difference Between Risk and Uncertainty

Post by roflwaffle » Tue Sep 19, 2017 6:28 pm

My feeling is that risk is used in the context of how well someone can stay the course. And it's tied to volatility through that. If you're particularly good at predicting what resources you will need and/or adjusting your lifestyle in response to volatility, your risk is minimal. If you aren't good at predicting what you will need and/or able/willing to adjust your lifestyle in response to volatility, your risk increases because you're more likely to draw down the resources you've invested, and/or you're more likely to do that when your investments are at a local minimum.

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Re: The Difference Between Risk and Uncertainty

Post by bobcat2 » Tue Sep 19, 2017 7:03 pm

Difference between pure risk and speculative risk. From the glossary of terms from IRMI (International Risk Management Institute).
speculative risk
Uncertainty about an event under consideration that could produce either a profit or a loss, such as a business venture or a gambling transaction. A pure risk is generally insurable while speculative risk is usually not.
pure risk
The risk involved in situations that present the opportunity for loss but no opportunity for gain. Pure risks are generally insurable, whereas speculative risks (which also present the opportunity for gain) generally are not.
Link to above definitions - https://www.irmi.com/online/insurance-g ... -risk.aspx


The difference between pure risk and speculative risk is the reason the definitions of risk from dictionaries is different than the definition of risk from finance and economics textbooks in my above post. The dictionaries are defining pure risk and the finance and econ texts are defining speculative risk. Notice though that the definition of risk is essentially the same among all the dictionaries, and the definition of risk is essentially the same among all the finance and econ texts.

I do quibble slightly with the above definition of speculative risk by the IRMI. It's true that a speculative risk can usually not be insured by conventional insurance. However, much speculative risk can be insured thru option contracts. An option is basically financial insurance.

The difference between the two types of risk is that pure risk there is downside risk (loss) and no change. In speculative risk there is in addition to loss and no change the possibility of gain. To my way of thinking, a big difference isn't whether both types of risks can be insured or not, but that speculative risk is usually taken voluntarily, while pure risk is very rarely taken voluntarily.

Moshe Milevsky is one financial economist who goes out of his way in his writings to distinguish between pure and speculative risk. He drilled it into me. :)
(W)hat would you say about the fairly frequently echoed phrase, "volatility is not risk?"
Volatility (standard deviation) is a way to measure speculative risk. A way to measure something is not the same thing as the definition of that something.

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Re: The Difference Between Risk and Uncertainty

Post by dbr » Fri Sep 22, 2017 10:13 am

nisiprius wrote:
Tue Sep 19, 2017 5:57 pm

BobK and Kevin, and any other who wish to comment... in the light of the two groups of definitions BobK has marshaled, what would you say about the fairly frequently echoed phrase, "volatility is not risk?"
I think it is a statement made in a convoluted discussion of risk where someone is trying to make a particular point. As such their point is probably valid, but the statement is not as a general pronouncement about risk or volatility. If it is intended as such a general pronouncement, it is a statement that should probably be ignored. The actual flaw is using that all the content resides in two terms which are used without definition.

If we take volatility to mean specifically the standard deviation of (annual) returns and that therefore volatility is one way of measuring risk rather than "being" risk, then there is a point there, maybe. But one can get very technical about this and say that standard deviation of returns is not "volatility" but a way of measuring volatility. That leaves some options as to whether volatility is or isn't risk.

In my mind statements like "volatility is not risk" is a pointless attempt to make an argument based on generalization rather than on logical detail. I don't know if there is a logical fallacy there, but it might be the nominalist argument that there are no universal objects, in this case "risk." But I don't think this is a philosophical debate. It isn't very hard to just think clearly and get the job done. Thinking clearly probably starts with defining terms and avoiding pronouncements such as "volatility is not risk."

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Re: The Difference Between Risk and Uncertainty

Post by nisiprius » Fri Sep 22, 2017 10:37 am

bobcat2 wrote:
Tue Sep 19, 2017 7:03 pm
Difference between pure risk and speculative risk. From the glossary of terms from IRMI (International Risk Management Institute).
speculative risk
Uncertainty about an event under consideration that could produce either a profit or a loss, such as a business venture or a gambling transaction. A pure risk is generally insurable while speculative risk is usually not.
pure risk
The risk involved in situations that present the opportunity for loss but no opportunity for gain. Pure risks are generally insurable, whereas speculative risks (which also present the opportunity for gain) generally are not.
Link to above definitions - https://www.irmi.com/online/insurance-g ... -risk.aspx
Thanks.

One point I want to make is that to my mind it is not true that only downside risk matters to ordinary investors. It seems to me that risk is measured relative to personal expectation. What I'm getting at is that if two investors, A and B, have, respectively, a low and a high stock allocation, if both of them do their planning based on assumption of bad, say tenth-percentile stock market performance, and investor B actually treats better performance as a windfall that is welcome, but not planned on or expected, then the upside risk of the high-stocks portfolio is not risk. It is, given investor B's plans, uncertainty that dosn't matter much.

If, on the other hand, based on the expected return of the portfolios, their historical average or median or something of the sort, investor B plans on the assumption that a high-stocks portfolio will outperform a low-stocks portfolio--if, for example, they lower their savings rate (or increase their withdrawal rate in retirement), then the upside risk matters--because it has induced behavior that causes the downside risk, if it shows up, to be more serious.

Thus, I think one can make a case that many pension plans are underfunded as a result--an indirect, behavior-mediated result--of the upside risks of stocks. But perhaps this is my own self-serving use of private definitions to support a desired conclusion.
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Re: The Difference Between Risk and Uncertainty

Post by dbr » Fri Sep 22, 2017 2:17 pm

nisiprius wrote:
Fri Sep 22, 2017 10:37 am


One point I want to make is that to my mind it is not true that only downside risk matters to ordinary investors. It seems to me that risk is measured relative to personal expectation. What I'm getting at is that if two investors, A and B, have, respectively, a low and a high stock allocation, if both of them do their planning based on assumption of bad, say tenth-percentile stock market performance, and investor B actually treats better performance as a windfall that is welcome, but not planned on or expected, then the upside risk of the high-stocks portfolio is not risk. It is, given investor B's plans, uncertainty that dosn't matter much.

If, on the other hand, based on the expected return of the portfolios, their historical average or median or something of the sort, investor B plans on the assumption that a high-stocks portfolio will outperform a low-stocks portfolio--if, for example, they lower their savings rate (or increase their withdrawal rate in retirement), then the upside risk matters--because it has induced behavior that causes the downside risk, if it shows up, to be more serious.

Thus, I think one can make a case that many pension plans are underfunded as a result--an indirect, behavior-mediated result--of the upside risks of stocks. But perhaps this is my own self-serving use of private definitions to support a desired conclusion.
Why not take your description as it stands and not feel obligated to label it?

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