Risk vs uncertainty

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
larryswedroe
Posts: 15711
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Risk vs uncertainty

Post by larryswedroe » Wed Dec 28, 2011 2:12 pm

Dug up this from a piece I wrote during the financial crisis. Thought it might be helpful


"There is an important distinction between risk and uncertainty. The difference is that risk exists when probabilities are known. For example, when we roll the dice, we can calculate precisely the odds of any outcome. And using actuarial tables, we can calculate the odds of a 65-year old living beyond age 85. Uncertainty exists when we cannot calculate the odds. An example would be the uncertainty of another attack such as the one we experienced on September 11, 2001. Unfortunately, investors often confuse the two concepts. The following is an example of confusing risk with uncertainty.

An insurance company might be willing to take on a certain amount of hurricane risk in Dade and Broward counties in Florida. They would price this risk based on approximately 100 years of data, the likelihood of hurricanes occurring, and the damage that they did. But only a foolish insurer would place such a large bet that if more or worse hurricanes occurred than had previously ever been experienced the company would go bankrupt. That would be ignoring uncertainty—that the future might not look like the past.

Individuals often make a similar mistake, causing them to decide on an equity allocation that exceeds their ability, willingness and need to take risk. The mistake is that individuals tend to view equities as closer to risk where the odds can be calculated precisely. This tendency appears when economic conditions are good. Their “ability” to estimate the odds gives investors a sense of confidence. That drives down the equity risk premium demanded by investors. And that drives up equity prices. However, during crises investors perception about equity investing shifts from one of risk to one of uncertainty. We often hear commentators use phrases like “there is a the lack of clarity or visibility.” Since investors prefer risky bets to uncertain bets, when the markets begin to appear to investors to become uncertain the risk premium demanded rises—and that is what causes severe bear markets.

The historical evidence is very clear that dramatic falls in prices leads to panicked selling as investors eventually reach their GMO point—the stomach screams “Get Me Out.” And selling begets more selling. Investors have demonstrated the unfortunate tendency to sell well after market declines have already occurred and buy well after rallies have long begun. The result is that they dramatically underperform the very mutual funds in which they invest. And the stocks they buy underperform after they buy them, and the stocks they sell go on to outperform after they are sold.
The reality is that investing in equities is always about uncertainty, not about risk. In fact, that is exactly why the equity risk premium has been so high. Investors demand a large risk premium to compensate them for taking uncertain “bets.” Those investors that recognize this will avoid the mistake of taking more risk than the have the ability, willingness or need to take. By avoiding that mistake, investors give themselves the greatest chance of also avoiding the mistake of letting their stomachs, and not their heads, make investment decisions. Stomachs rarely make good decisions."

No one can estimate properly the odds of say Iran launching a nuclear weapon or blocking the straits of Hormuz. But what we can do is manage the amount and type of risks to which we expose our portfolios (the potential for losses), depending on our ability, willingness or need to take risk. And thus while equity investing is about uncertainty, events we cannot estimate properly the odds of their occurring let alone predict or control, we can and should focus on the things we actually do control, including not just the AA but costs and tax efficiency. And we need to be humble about our ability to estimate returns or even the dispersion of potential outcomes, or alternative universes if you like.

I hope the above is helpful

Best
Larry

User avatar
Dick Purcell
Posts: 520
Joined: Tue Oct 26, 2010 1:58 am

Re: Risk vs uncertainty

Post by Dick Purcell » Wed Dec 28, 2011 3:40 pm

Larry –

NO NO NO!

The distinction you make is important But the labeling is unacceptable. It reinforces the financial engineers’ irresponsible misuse of the fear-word risk.

It’s as bad as their misuse of the word expected. Maybe worse.

If we want to zero in on why, despite Mr. Bogle’s 35-year campaign, over 90% of people’s fund money is still in active funds, finance professors’ continued use of those two terms of deception would be a good place to start.

In responsible professions, eg real engineering (not financial), risk assessment requires consideration of two things – the probabilities of adverse events and how adverse those events would be.

For most investors, the principal potential adversity is money shortfall when they are too old to do anything about it. Return-rate uncertainty, measurable or not, does not address that.

(I am reminded once again of Taylor’s common sense definition of risk as financial shortfall danger for future financial goals, which Magician and others helped refine.)

Return-rate standard deviation doesn’t even define return-rate probabilities – it doesn’t specify what it is deviating from. And it reveals nothing about the adversity of the consequences.

To assess an investor’s real risk, in addition to return-rate uncertainty we need the mean, the amounts and times of investments and future needs and goals, effects of compounding along the way, fees and taxes and inflation – and assessment of adversities of shortfalls, best judged by the investor.

For real risk, return-rate standard deviation and any additional return-rate uncertainty are only essential raw materials to be applied along with others in further analysis.

Calling return-rate standard deviation “risk” has the perverse effect that as the typical investor moves along the frontier to portfolios labeled as least in “risk,” she increases her real risk.

That mislabeling is also wonderful for the actively-managed-fund financial industry. It helps misfocus investors’ attention on their short-term fears for the individual year, where they cannot see the terrible long-term cost of high active-fund fees.

Please! With all your expertise and influence, you can help fight this terrible pair of labels of deception.

Dick Purcell

User avatar
nisiprius
Advisory Board
Posts: 36851
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Risk vs uncertainty

Post by nisiprius » Wed Dec 28, 2011 3:47 pm

Oops--see Dick Purcell is commenting similarly, don't want to throw away my lovely post but don't mean to be "piling on."

Larry, I believe you're using Frank Knight's* definitions of "risk" and "uncertainty." A recent thread commented on the issue of the public misunderstanding words like "expected" in financial writing, and I think there's a potential similar issue here. I would say that as you use them they are almost technical terms. Looking them up at http://www.m-w.com it is interesting to note the dictionary meanings of "risk" include only the negative aspects. The dictionary does not capture "risk" in the sense of standard deviation, of fluctuation either way, of volatility. And the definitions of risk use alarming words suggesting a serious matter: injury, hazard, peril:
possibility of loss or injury : peril
2
: someone or something that creates or suggests a hazard
3
a : the chance of loss or the perils to the subject matter of an insurance contract; also : the degree of probability of such loss
b : a person or thing that is a specified hazard to an insurer
c : an insurance hazard from a specified cause or source <war risk>
4
: the chance that an investment (as a stock or commodity) will lose value
On the other hand, "uncertainty" references the definition of "uncertain," which means
: indefinite, indeterminate <the time of departure is uncertain>
2
: not certain to occur : problematical <his success was uncertain>
3
: not reliable : untrustworthy <an uncertain ally>
4
a : not known beyond doubt : dubious <an uncertain claim>
b : not having certain knowledge : doubtful <remains uncertain about her plans>
c : not clearly identified or defined <a fire of uncertain origin>
5
: not constant : variable, fitful <an uncertain breeze>
Notice that the dictionary definitions of "uncertain" are rather less alarming, and definition 5 does include the notion of bidirectional variability.

Synonyms for "risk" are listed as "hazard, imminence, menace, peril, pitfall, danger, threat, trouble."

Synonyms for "uncertain" are listed as "capricious, changeable, changeful, flickery, fluctuating, fluid, inconsistent, inconstant, mercurial, mutable, skittish, temperamental, fickle, unpredictable, unsettled, unstable, unsteady, variable, volatile."

In fact, it almost seems to me as if the common definitions for "risk" and "uncertainty" are almost swapped around from the meanings given to them by Knight. The dictionary's "risk" means rare, catastrophic. The dictionary's definition of "uncertain" means vague, variable, wishy-washy. At any rate, the important distinction you and Knight wished to capture is certainly not captured by the ordinary meaning of the two words Knight chose to use.

*Frank Knight, 1885-1972, was a University of Chicago economist who wrote an influential book, Risk, Uncertainty, and Profit, available online here.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

dbr
Posts: 27207
Joined: Sun Mar 04, 2007 9:50 am

Re: Risk vs uncertainty

Post by dbr » Wed Dec 28, 2011 3:58 pm

I'll stay out of this one, though there could be much to be said.

User avatar
bob90245
Posts: 6511
Joined: Mon Feb 19, 2007 8:51 pm

Re: Risk vs uncertainty

Post by bob90245 » Wed Dec 28, 2011 5:14 pm

I'll stay out, too. What say you, Bobcat?
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

AndroAsc
Posts: 1126
Joined: Sat Nov 21, 2009 7:39 am

Re: Risk vs uncertainty

Post by AndroAsc » Wed Dec 28, 2011 5:19 pm

I was recalling the other thread on "expected returns" and how some people got really mad about the term, until somebody pointed it out that it gets the name from probability theory.

No offense, but why should the academic community (the ones doing these finance research) intentionally change terms simply because the general less educated population cannot understand it or simply will not make any effort to understand it? My approach is to learn the jargon instead of hiding behind reasons like "it is confusing for the layman".

If Larry is using the terminology established in academic/financial literature so be it. Just learn it.

EDIT: Although in my opinion, I do find it weird that risk = standard deviation. I would think that intuitively uncertainty = standard deviation, since that is the definition used in most sciences. For e.g., I measured that the pen was 10 +/- 1cm long. The +/- 1cm is the uncertainty of the measurement. When doing probability studies, the +/- value will be replaced with the standard deviation. But then again, every field has its own jargon and it is sometimes unique and contrary to the way it is used in other fields.
Last edited by AndroAsc on Wed Dec 28, 2011 5:28 pm, edited 5 times in total.

larryswedroe
Posts: 15711
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: Risk vs uncertainty

Post by larryswedroe » Wed Dec 28, 2011 5:21 pm

AndroAsc
Exactly, that is the point I tried to make earlier
Best
Larry

User avatar
Lbill
Posts: 4997
Joined: Thu Mar 13, 2008 11:25 pm
Location: Somewhere between Up and Down

Re: Risk vs uncertainty

Post by Lbill » Wed Dec 28, 2011 5:37 pm

One of the best discussions of "uncertainty" is given by Pastor & Stambaugh. The authors show that there are several components of predictive uncertainty, including:

> i.i.d. uncertainty: the uncertainty of returns conditioned on the traditional random walk assumption that returns are distributed identically and independently over time.
> uncertainty about future expected returns
> uncertainty about current expected returns
> estimation risk: uncertainty about the parameters of the joint process generating returns, expected returns, and the observed predictors.

Management of "Risk", traditionally defined as the short term volatility of returns, is a rather trivial aspect of financial management - although it lends itself best to treatment with the statistical tools of modern portfolio theory. If you have a hammer then the future looks like a nail - but it is not actually a nail.
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

User avatar
Dick Purcell
Posts: 520
Joined: Tue Oct 26, 2010 1:58 am

Re: Risk vs uncertainty

Post by Dick Purcell » Wed Dec 28, 2011 5:54 pm

Larry –

Sorry!

In my rant about use of the term risk, I took attention from your underlying point. Sorry about that.

Terminogy aside, your point that uncertainty >> calculated standard deviation is so important, and generally overlooked. I hope I haven’t obscured that point, and hope it gets more attention and discussion in this thread.

Dick Purcell

User avatar
VictoriaF
Posts: 18597
Joined: Tue Feb 27, 2007 7:27 am
Location: Black Swan Lake

Re: Risk vs uncertainty

Post by VictoriaF » Wed Dec 28, 2011 6:26 pm

AndroAsc wrote:I was recalling the other thread on "expected returns" and how some people got really mad about the term, until somebody pointed it out that it gets the name from probability theory.

No offense, but why should the academic community (the ones doing these finance research) intentionally change terms simply because the general less educated population cannot understand it or simply will not make any effort to understand it? My approach is to learn the jargon instead of hiding behind reasons like "it is confusing for the layman".

If Larry is using the terminology established in academic/financial literature so be it. Just learn it.

EDIT: Although in my opinion, I do find it weird that risk = standard deviation. I would think that intuitively uncertainty = standard deviation, since that is the definition used in most sciences. For e.g., I measured that the pen was 10 +/- 1cm long. The +/- 1cm is the uncertainty of the measurement. When doing probability studies, the +/- value will be replaced with the standard deviation. But then again, every field has its own jargon and it is sometimes unique and contrary to the way it is used in other fields.
You are making an assumption that there is some homogeneous scientific community that has reached agreements on fundamental concepts and definitions, and that individual scientists have accepted these core concepts before they started pushing on various sides of the envelope.

This is not the case. Scientists frequently do not agree on the most fundamental concepts and fundamental definitions. Just because the same definitions show up in economics and finance textbooks, and millions of students read these books -- required for them to read by their professors -- does not mean that what textbooks say is widely accepted.

The Knightian distinction between risk and uncertainty seems clever until you get into the contradictions pointed out by Nisiprius.

Risk is always negative, nobody(*) considers risk with a positive connotation. Uncertainty, on the other hand, is closely related to the probability theory, decision making and game theory and it can be positive or negative.

Consider, for example, how risk of information systems is defined.
NIST SP800-30 wrote: Risk assessments identify, prioritize, and estimate risk to organizational operations (i.e., mission, functions, image, and reputation), organizational assets, individuals, other organizations, and the Nation, resulting from the operation and use of information systems. The purpose of the risk assessment component is to identify: (i) threats to organizations or threats directed through organizations against other organizations or the Nation; (ii) vulnerabilities internal and external to organizations; (iii) impact (i.e., harm) to organizations that may occur given the potential for threats exploiting vulnerabilities; and (iv) likelihood that harm will occur. The end result is a determination of risk (i.e., the degree of harm and likelihood of harm occurring).
This definition easily maps into a common financial risk formula:
Risk = Consequences x Probability of occurrence.

In the NIST formulation, consequences are referred to as "(iii) impact (i.e., harm)" and probabilities are referred to as "likelihood that harm will occur." The likelihood of harm occurring is related to the probabilities of "(i) threats" and "(ii) vulnerabilities." Note the use of the words "harm," "threats," and "vulnerabilities." There is nothing positive about risk!

NIST is the National Institute of Science and Technology. They are also "real scientists." :-)

Victoria
(*) EDIT. Nobody, except 555. See his message that follows.
Last edited by VictoriaF on Wed Dec 28, 2011 7:01 pm, edited 1 time in total.
WINNER of the 2015 Boglehead Contest. | Every joke has a bit of a joke. ... The rest is the truth. (Marat F)

555
Posts: 4955
Joined: Thu Dec 24, 2009 7:21 am

Re: Risk vs uncertainty

Post by 555 » Wed Dec 28, 2011 6:47 pm

VictoriaF wrote:Risk is always negative, nobody considers risk with a positive connotation.
I do. I must be nobody. :(

jginseattle
Posts: 726
Joined: Fri Jul 01, 2011 7:33 pm

Re: Risk vs uncertainty

Post by jginseattle » Wed Dec 28, 2011 7:06 pm

555 wrote:
VictoriaF wrote:Risk is always negative, nobody considers risk with a positive connotation.
I do. I must be nobody. :(
Yes. Why would anyone take risk if there was no "positive connotation"?

plnelson
Posts: 704
Joined: Wed Feb 24, 2010 6:49 pm

Re: Risk vs uncertainty

Post by plnelson » Wed Dec 28, 2011 7:09 pm

larryswedroe wrote:Dug up this from a piece I wrote during the financial crisis. Thought it might be helpful


"There is an important distinction between risk and uncertainty. The difference is that risk exists when probabilities are known.
. . .
I hope the above is helpful

Best
Larry
So, is there any example of an investment decision where probabilities are known? Offhand I can't think of one. Yet the term "risk" is used frequently when discussing investment decisions or comparing different investment vehicles. I think that either your use of the term "risk" is incorrect or the rest of the investment community is using the term "risk" incorrectly, because I can't think of a single example of an investment parameter where we can actually calculate the risk. Even if we are talking about, say, the risk of a AA+ rated commercial bond defaulting, that calculation is based on past performance, and each and every one of us knows that past performance does not indicate future performance.

If I go to Las Vegas I might know what the risk is because either the nature of the game or the knowledge of the house odds is fixed. Likewise if I buy a lottery ticket, based on how many numbers have to line up to win I can compute what the chances are that I could have a winning ticket. But I don't see how the probability of a stock going up x% or the probability that interest rates might rise or fall by x% can ever be known. So should the term "risk" be banished from investment discussions?

Harold
Posts: 3154
Joined: Sat Mar 03, 2007 7:50 pm
Location: San Francisco

Re: Risk vs uncertainty

Post by Harold » Wed Dec 28, 2011 7:19 pm

AndroAsc wrote:I was recalling the other thread on "expected returns" and how some people got really mad about the term, until somebody pointed it out that it gets the name from probability theory.

No offense, but why should the academic community (the ones doing these finance research) intentionally change terms simply because the general less educated population cannot understand it or simply will not make any effort to understand it? My approach is to learn the jargon instead of hiding behind reasons like "it is confusing for the layman".

If Larry is using the terminology established in academic/financial literature so be it. Just learn it.

EDIT: Although in my opinion, I do find it weird that risk = standard deviation. I would think that intuitively uncertainty = standard deviation, since that is the definition used in most sciences. For e.g., I measured that the pen was 10 +/- 1cm long. The +/- 1cm is the uncertainty of the measurement. When doing probability studies, the +/- value will be replaced with the standard deviation. But then again, every field has its own jargon and it is sometimes unique and contrary to the way it is used in other fields.
If someone's writing for the academic community, and doesn't much care whether anyone outside the community will understand (if they want to read it, they need to learn the terms!) using established terminology is perfect.

If someone is writing in hopes of reaching people outside of the academic community, yet insists on using established terminology without making an effort to use language the larger community will understand, it's a demonstration of insufficient (even inconsiderate) communication skills. (Could even be taken as a touch of arrogance -- what I have to say is important enough that they need to put in some work to understand me!)

larryswedroe
Posts: 15711
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: Risk vs uncertainty

Post by larryswedroe » Wed Dec 28, 2011 7:43 pm

plnelson

Like I said, the uncertainty creates the risks that investors bear. But there are risks that are prudent to take, because they are compensated, and risks that are not, because they are uncompensated, idiosyncratic risks that can be diversified away and thus the market does not reward you for taking them.
Best
Larry

User avatar
GregLee
Posts: 1748
Joined: Wed Oct 27, 2010 3:54 pm
Location: Waimanalo, HI

Re: Risk vs uncertainty

Post by GregLee » Wed Dec 28, 2011 7:56 pm

larryswedroe wrote: I hope the above is helpful
Not at all. You seem to be deeply into the social scientist's confusion that there is an epistemological difference between knowledge you gain by counting and calculation versus knowledge gained in other ways. I think what you've said here is all wrong.
Greg, retired 8/10.

User avatar
DRiP Guy
Posts: 2237
Joined: Tue Feb 20, 2007 4:54 pm

Re: Risk vs uncertainty

Post by DRiP Guy » Wed Dec 28, 2011 8:00 pm

(being serious)

Is our English language failing us, and we need a *new* word?

I recall that there was not really an English equivalent to schadenfreude, so we had to co-opt it...

User avatar
VictoriaF
Posts: 18597
Joined: Tue Feb 27, 2007 7:27 am
Location: Black Swan Lake

Re: Risk vs uncertainty

Post by VictoriaF » Wed Dec 28, 2011 8:04 pm

bob90245 wrote:I'll stay out, too. What say you, Bobcat?
Paging bobcat2!

Victoria
WINNER of the 2015 Boglehead Contest. | Every joke has a bit of a joke. ... The rest is the truth. (Marat F)

User avatar
magician
Posts: 1568
Joined: Mon May 02, 2011 1:08 am
Location: Yorba Linda, CA
Contact:

Re: Risk vs uncertainty

Post by magician » Wed Dec 28, 2011 9:44 pm

VictoriaF wrote:Risk is always negative, nobody(*) considers risk with a positive connotation.
I consult in project risk management, and I, like 555, believe (advocate, in fact) that risk includes both negative outcomes (threats) and positive outcomes (opportunities). Some risk managers believe that risk should only include negative outcomes; I believe that the project team members with whom I work are smart enough to distinguish threats from opportunities - and to determine the proper way to handle each type when it arises - so there's no disadvantage to classifying both as risks.

Sorry.
Simplify the complicated side; don't complify the simplicated side.

User avatar
magician
Posts: 1568
Joined: Mon May 02, 2011 1:08 am
Location: Yorba Linda, CA
Contact:

Re: Risk vs uncertainty

Post by magician » Wed Dec 28, 2011 9:46 pm

DRiP Guy wrote:I recall that there was not really an English equivalent to schadenfreude, so we had to co-opt it . . . .
English doesn't just borrow words; on occasion, English has pursued other languages down alleyways to beat them unconscious and rifle their pockets for new vocabulary.

-- James Nicoll
Simplify the complicated side; don't complify the simplicated side.

User avatar
DRiP Guy
Posts: 2237
Joined: Tue Feb 20, 2007 4:54 pm

Re: Risk vs uncertainty

Post by DRiP Guy » Wed Dec 28, 2011 9:59 pm

magician wrote:
DRiP Guy wrote:I recall that there was not really an English equivalent to schadenfreude, so we had to co-opt it . . . .
English doesn't just borrow words; on occasion, English has pursued other languages down alleyways to beat them unconscious and rifle their pockets for new vocabulary.

-- James Nicoll
I like that!
:lol

ilmartello
Posts: 1075
Joined: Sun Nov 06, 2011 6:59 pm

Re: Risk vs uncertainty

Post by ilmartello » Wed Dec 28, 2011 10:18 pm

i have no idea why people nit-pick over what word is used to define different concepts. It's important he made a distinction between two different concepts and explained how they are different.

pkcrafter
Posts: 13096
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Risk vs uncertainty

Post by pkcrafter » Wed Dec 28, 2011 10:32 pm

This is an important discussion, at least to me. I'm hoping some useful or significant understanding for the average investor comes from it because enlightening the average investor is my goal.
Risk is always negative, nobody considers risk with a positive connotation.
Right, and what is wrong with that? I'm only considering the average investor. Risk and the acceptance of risk for gain are two different things.

What Larry has said is correct when it comes to academics and learned investors, but it does not convey risk to the average investor.

Dick Purcell wrote:
(I am reminded once again of Taylor’s common sense definition of risk as financial shortfall danger for future financial goals, which Magician and others helped refine.)
Up until now I thought this was a very good definition of risk. It does cover an important aspect of investing, but it says that an investor needs to take on some stock market risk, and it implies there is a balance between taking that risk and not achieving a goal if the risk is not taken. This is good, but it does not define the risk of investing in stocks, so let me define it. The risk of investing in stocks is you can lose all of your money. Anyone want to argue that?

Arguments may claim that you won't lose all your money if you hold. OK, but in 1929 stocks lost ~90%, and the market came back. Yes, it did, but it took 22 years. It has come back in all drawdowns, but again, there is no certainty that says it will. Furthermore, a full recovery that takes 22 years may not be of much use to shorter term investors or even long term investors. A well known axiom that maximum stock market loss is equal to half the equity exposure is false. This was the case in the last three major market drawdowns, but is it reliable. Nope. Investors who believe it and set AA based on it may very well sell when the market drops by 70% or 80% because it's beyond their conception of risk and they feel out of control. Panic.

Risk as defined by academics (Knight) is one thing, uncertainty another. The academic definition of uncertainty is as AndorAsc defined it:
For e.g., I measured that the pen was 10 +/- 1cm long. The +/- 1cm is the uncertainty of the measurement.
That doesn't help: the useful definition of uncertainty should be summed up as --black swan. It isn't the degree of deviation from the expected that is the problem, but the totally unexpected. How do you quantify that? Another way to see this is risk can be broken down into SD, uncertainty and unknown. It's the unknown that will get you. If you understand this, then you know the risk of putting all saved assets into stocks.

Paul
Last edited by pkcrafter on Wed Dec 28, 2011 11:11 pm, edited 2 times in total.
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.

User avatar
DRiP Guy
Posts: 2237
Joined: Tue Feb 20, 2007 4:54 pm

Re: Risk vs uncertainty

Post by DRiP Guy » Wed Dec 28, 2011 10:39 pm

ilmartello wrote:i have no idea why people nit-pick over what word is used to define different concepts. It's important he made a distinction between two different concepts and explained how they are different.
Because people have (and will) continue to transpose them.

User avatar
GregLee
Posts: 1748
Joined: Wed Oct 27, 2010 3:54 pm
Location: Waimanalo, HI

Re: Risk vs uncertainty

Post by GregLee » Wed Dec 28, 2011 10:53 pm

magician wrote:... smart enough to distinguish threats from opportunities - and to determine the proper way to handle each type when it arises - so there's no disadvantage to classifying both as risks.

Sorry.
People and asteroids are sufficiently dissimilar that no confusion would be caused by classifying them as the same. Therefore, they're the same. And in fact all sufficiently dissimilar things must be the same. Hmm. I think this may be a new theory, so don't be sorry.
Greg, retired 8/10.

User avatar
bob90245
Posts: 6511
Joined: Mon Feb 19, 2007 8:51 pm

Re: Risk vs uncertainty

Post by bob90245 » Wed Dec 28, 2011 11:09 pm

pkcrafter wrote:Arguments may claim that you won't lose all your money if you hold. OK, but in 1929 stocks lost ~90%, and the market came back. Yes, it did, but it took 22 years. It has come back in all drawdowns, but again, there is no certainty that says it will. Furthermore, a full recovery that takes 22 years may not be of much use to shorter term investors or even long term investors.
But do investors dump all their money all in stocks and then, like Rumpelstiltskin, take a 22-year nap? Maybe instead, they feed small but steady amounts over 22 years. The following chart shows real values for $1,000 invested each year from 1929-1950 (22 years or $22,000 total contributions). At the end of 1950, the accumulated balance grew to $47,000. Click image for full size.

Image
Source: http://www.bobsfinancialwebsite.com/download.html#DCA
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

kontango
Posts: 114
Joined: Sun Dec 18, 2011 11:27 am

Re: Risk vs uncertainty

Post by kontango » Wed Dec 28, 2011 11:16 pm

The confusion about terms here seems to have more to do with lack of understanding of the terms than a mislabeling of them. Like it or not, finance/investing is technical. And it has its own vernacular as do most technical fields...and that vernacular does not alway neatly map into our common day usage. The only choices we have are either learn the field or curse it. Only one of those choices is constructive.

And, complexity of the field is one (very valid) reason many folks use financial advisors when it comes to their life savings.

ilmartello
Posts: 1075
Joined: Sun Nov 06, 2011 6:59 pm

Re: Risk vs uncertainty

Post by ilmartello » Wed Dec 28, 2011 11:18 pm

hey look there's megan fox

pkcrafter
Posts: 13096
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Risk vs uncertainty

Post by pkcrafter » Thu Dec 29, 2011 12:05 am

Bob, while your chart may seem comforting, it does not ameliorate the potential devastation of market risk. Most investors would not be able to hold through such a drawdown if 100% invested in stocks because being 100% invested in stock implies the investor does not believe such an event could ever happen. Furthermore, are you suggesting this will be the outcome next time?

kontango wrote:
And, complexity of the field is one (very valid) reason many folks use financial advisors when it comes to their life savings.
Most investors don't know they don't know, and most financial advisors and brokers don't understand risk either.

Paul
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.

User avatar
DRiP Guy
Posts: 2237
Joined: Tue Feb 20, 2007 4:54 pm

Re: Risk vs uncertainty

Post by DRiP Guy » Thu Dec 29, 2011 7:32 am

kontango wrote:The confusion about terms here seems to have more to do with lack of understanding of the terms than a mislabeling of them.
Conceded.
Like it or not, finance/investing is technical.
Conceded.
And it has its own vernacular as do most technical fields...

Conceded.
and that vernacular does not alway neatly map into our common day usage.

Conceded.
The only choices we have are either learn the field or curse it.

Ah, there's the rub! I disagree emphatically. If there is a chance to begin to use less ambiguous language, even if that means coining new words or phrases, such that clearer and more precise meaning is conveyed, without the danger of misunderstanding by trying to use terms that have different meanings depending on context... well, how can that be a bad thing?
Only one of those choices is constructive.
I think that particular false dichotomy was mooted in my disagreeing that there are only two choices.
And, complexity of the field is one (very valid) reason many folks use financial advisors when it comes to their life savings.
Exactly! At the risk of being a redundant quoter, as Cool Hand Luke sarcastically drawled:

"Yeah, them poor old bosses need all the help they can git...."

peppers
Posts: 1342
Joined: Tue Oct 25, 2011 7:05 pm

Re: Risk vs uncertainty

Post by peppers » Thu Dec 29, 2011 9:07 am

pkcrafter : agree, I'm partial to the Donald Rummsfeld quote "...unknown unknowns..."
dripguy: love the avatar, Cool Hand Luke...great movie
"..the cavalry ain't comin' kid, you're on your own..."

User avatar
spanky123
Posts: 66
Joined: Sun May 22, 2011 11:15 am

Re: Risk vs uncertainty

Post by spanky123 » Thu Dec 29, 2011 10:22 am

GregLee wrote:
larryswedroe wrote: I hope the above is helpful
Not at all. You seem to be deeply into the social scientist's confusion that there is an epistemological difference between knowledge you gain by counting and calculation versus knowledge gained in other ways. I think what you've said here is all wrong.
What's right (correct) then? Please elaborate and expound!

User avatar
spanky123
Posts: 66
Joined: Sun May 22, 2011 11:15 am

Re: Risk vs uncertainty

Post by spanky123 » Thu Dec 29, 2011 10:25 am

kontango wrote:Like it or not, finance/investing is technical.
However, it is definitely not scientific.

User avatar
spanky123
Posts: 66
Joined: Sun May 22, 2011 11:15 am

Re: Risk vs uncertainty

Post by spanky123 » Thu Dec 29, 2011 10:43 am

Uncertainty = ?
Risk = A state of uncertainty where outcome could be + or -.

User avatar
bob90245
Posts: 6511
Joined: Mon Feb 19, 2007 8:51 pm

Re: Risk vs uncertainty

Post by bob90245 » Thu Dec 29, 2011 11:25 am

pkcrafter wrote:Bob, while your chart may seem comforting, it does not ameliorate the potential devastation of market risk. Most investors would not be able to hold through such a drawdown if 100% invested in stocks because being 100% invested in stock implies the investor does not believe such an event could ever happen.
Hey, I never said the drawdown from the 1929 peak wasn't devasting for those who experienced it. My counter is that for those who were able to stay the course (assuming they remained employed) and continued with their systematic investing program, the result at the end of 22 years was OK ($47,000 accumulated balanced from $22,000 contributions over 22 years).
pkcrafter wrote:Furthermore, are you suggesting this will be the outcome next time?
I don't possess a clear crystal ball. But the growth of stocks reflects a healthy economy. If the economy ever remains stagnant for more than two decades, your stock portfolio would likely be the least of your concerns.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

Bongleur
Posts: 2066
Joined: Fri Dec 03, 2010 10:36 am

Re: Risk vs uncertainty

Post by Bongleur » Thu Dec 29, 2011 12:01 pm

bob90245 wrote:The following chart shows real values for $1,000 invested each year from 1929-1950 (22 years or $22,000 total contributions). At the end of 1950, the accumulated balance grew to $47,000. Click image for full size.

Image
Source: http://www.bobsfinancialwebsite.com/download.html#DCA

Hmmm. Maybe it should be a law that all cumulative gain charts presented by investment companies also show the cumulative amount of principle. The visual effect is informative.
Seeking Iso-Elasticity. | Tax Loss Harvesting is an Asset Class. | A well-planned presentation creates a sense of urgency. If the prospect fails to act now, he will risk a loss of some sort.

pkcrafter
Posts: 13096
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Risk vs uncertainty

Post by pkcrafter » Thu Dec 29, 2011 12:31 pm

Bob wrote:
I don't possess a clear crystal ball. But the growth of stocks reflects a healthy economy.

I somewhat agree that growth of stocks reflects a healthy economy, or that faith in the economy and of capitalism itself is necessary to invest in stocks at all. But withstanding a loss like 1929 is much easier to accept when looking at a historical chart as opposed to sitting in the middle of it.

My whole point of mentioning the '29 crash was to remind investors that it did happen and there is nothing to prevent it from happening again. That seems to be at least one way of communicating the power of risk to average investors. As EFMoody says, investors aren't risk averse, they are loss averse.

Paul
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.

User avatar
GregLee
Posts: 1748
Joined: Wed Oct 27, 2010 3:54 pm
Location: Waimanalo, HI

Re: Risk vs uncertainty

Post by GregLee » Thu Dec 29, 2011 1:00 pm

spanky123 wrote: What's right (correct) then? Please elaborate and expound!
Larry wrote: "There is an important distinction between risk and uncertainty. The difference is that risk exists when probabilities are known." Part of what he is getting at, I guess, is the difference statisticians make between statistics calculated from measurements, like the sample mean, and the parameters of a distribution, like the mean of a normal distribution. The distribution is a theory you make about a population, based on a sample, so probabilities associated with it are not known facts about the population, they are part of your theorizing. "Risk" might refer to a known fact about the sample, the sample standard deviation, or a parameter of the normal distribution you are fitting to the sample, the distribution's standard deviation. It's the difference between fact and theory, and certainly it's important to keep these apart. But it's not a difference that concerns precision or calculation. Probabilities don't become known because they are derived by calculation. You can calculate from observations or calculate from theories, and the fact that there is precise calculation going on doesn't make your conclusions any more or less theoretical.
Greg, retired 8/10.

hamishdad
Posts: 314
Joined: Mon Jan 21, 2008 2:16 pm

Re: Risk vs uncertainty

Post by hamishdad » Thu Dec 29, 2011 1:12 pm

I'm not sure how someone determines their ability to lose money.

User avatar
bob90245
Posts: 6511
Joined: Mon Feb 19, 2007 8:51 pm

Re: Risk vs uncertainty

Post by bob90245 » Thu Dec 29, 2011 1:34 pm

hamishdad wrote:I'm not sure how someone determines their ability to lose money.
Simple answer. Who has greater ability to withstand a loss from their nest egg: a young business woman with a promising career or an elderly widow with no other means of support besides Social Security?
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

pkcrafter
Posts: 13096
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Risk vs uncertainty

Post by pkcrafter » Thu Dec 29, 2011 1:35 pm

hamishdad wrote:I'm not sure how someone determines their ability to lose money.
I think you can determine your financial ability to lose money, but the emotional trigger is usually only realized after a failure to hold.


Paul
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.

SP-diceman
Posts: 3968
Joined: Sun Oct 05, 2008 9:17 am

Re: Risk vs uncertainty

Post by SP-diceman » Thu Dec 29, 2011 1:41 pm

hamishdad wrote:I'm not sure how someone determines their ability to lose money.
We do it every day.
What you buy, where you live, what you do, and what you eat.



Thanks
SP-diceman

SP-diceman
Posts: 3968
Joined: Sun Oct 05, 2008 9:17 am

Re: Risk vs uncertainty

Post by SP-diceman » Thu Dec 29, 2011 1:43 pm

Risk is what you know, uncertainty is what you don’t.


:)

User avatar
VictoriaF
Posts: 18597
Joined: Tue Feb 27, 2007 7:27 am
Location: Black Swan Lake

Re: Risk vs uncertainty

Post by VictoriaF » Thu Dec 29, 2011 1:46 pm

jginseattle wrote:
555 wrote:
VictoriaF wrote:Risk is always negative, nobody considers risk with a positive connotation.
I do. I must be nobody. :(
Yes. Why would anyone take risk if there was no "positive connotation"?
Risk is a "necessary evil" for getting something else in return. Consider the efficient frontier. It calls for minimizing risk for a given level of expected return.

Victoria
WINNER of the 2015 Boglehead Contest. | Every joke has a bit of a joke. ... The rest is the truth. (Marat F)

User avatar
CaliJim
Posts: 2984
Joined: Sun Feb 28, 2010 8:47 pm
Location: California, near the beach

Re: Risk vs uncertainty

Post by CaliJim » Thu Dec 29, 2011 2:24 pm

GregLee wrote:
spanky123 wrote: What's right (correct) then? Please elaborate and expound!
Larry wrote: "There is an important distinction between risk and uncertainty. The difference is that risk exists when probabilities are known." Part of what he is getting at, I guess, is the difference statisticians make between statistics calculated from measurements, like the sample mean, and the parameters of a distribution, like the mean of a normal distribution. The distribution is a theory you make about a population, based on a sample, so probabilities associated with it are not known facts about the population, they are part of your theorizing. "Risk" might refer to a known fact about the sample, the sample standard deviation, or a parameter of the normal distribution you are fitting to the sample, the distribution's standard deviation. It's the difference between fact and theory, and certainly it's important to keep these apart. But it's not a difference that concerns precision or calculation. Probabilities don't become known because they are derived by calculation. You can calculate from observations or calculate from theories, and the fact that there is precise calculation going on doesn't make your conclusions any more or less theoretical.
Thank you for this insight.

555
Posts: 4955
Joined: Thu Dec 24, 2009 7:21 am

Re: Risk vs uncertainty

Post by 555 » Thu Dec 29, 2011 2:44 pm

VictoriaF wrote:
jginseattle wrote:
555 wrote:
VictoriaF wrote:Risk is always negative, nobody considers risk with a positive connotation.
I do. I must be nobody. :(
Yes. Why would anyone take risk if there was no "positive connotation"?
Risk is a "necessary evil" for getting something else in return. Consider the efficient frontier. It calls for minimizing risk for a given level of expected return.
Victoria
It's not just the positive expected return that you take risk for that is a positive, it is also the risk of exceding expected returns that is a positive.

User avatar
magician
Posts: 1568
Joined: Mon May 02, 2011 1:08 am
Location: Yorba Linda, CA
Contact:

Re: Risk vs uncertainty

Post by magician » Thu Dec 29, 2011 3:53 pm

VictoriaF wrote:In the NIST formulation, consequences are referred to as "(iii) impact (i.e., harm)" and probabilities are referred to as "likelihood that harm will occur." The likelihood of harm occurring is related to the probabilities of "(i) threats" and "(ii) vulnerabilities." Note the use of the words "harm," "threats," and "vulnerabilities." There is nothing positive about risk!
From the Project Management Institute's Project Management Body of Knowledge (PMBOK), 3rd Edition:

Risk: An uncertain event or condition that, if it occurs, has a positive or negative effect on a project’s objectives. (Emphasis added.)

There is a sizable contingent who believe that there is something positive about risk.
Simplify the complicated side; don't complify the simplicated side.

Fallible
Posts: 6534
Joined: Fri Nov 27, 2009 4:44 pm
Contact:

Re: Risk vs uncertainty

Post by Fallible » Thu Dec 29, 2011 3:59 pm

555 wrote:
VictoriaF wrote:
jginseattle wrote:
555 wrote:
VictoriaF wrote:Risk is always negative, nobody considers risk with a positive connotation.
I do. I must be nobody. :(
Yes. Why would anyone take risk if there was no "positive connotation"?
Risk is a "necessary evil" for getting something else in return. Consider the efficient frontier. It calls for minimizing risk for a given level of expected return.
Victoria
It's not just the positive expected return that you take risk for that is a positive, it is also the risk of exceding expected returns that is a positive.
To me, risk in and of itself and by its definition, is negative. What can be positive is when risk is understood and dealt with properly to minimize its negativity.

As for Larry's good post, which I admit I didn't always fully understand, I see "risk and uncertainty" as more like calculated risk and risk. And wouldn't calculated risk include not just number crunching but an individual's tolerance for it (which would be very hard to calculate since individuals must know themselves quite well to know how they would react in various markets}?
Bogleheads® wiki | Investing Advice Inspired by Jack Bogle

User avatar
Dick Purcell
Posts: 520
Joined: Tue Oct 26, 2010 1:58 am

Re: Risk vs uncertainty

Post by Dick Purcell » Thu Dec 29, 2011 4:35 pm

It is appalling, downright sickening, to see right here in Bogleheads there are people who persist in the deceptive malpractice of mislabeling return-rate standard deviation as “risk” –- thereby aiding the active-fund enemies of Bogle in keeping over 90% of the people’s fund money in actively managed funds. Your deceptive malpractice scares people into focusing on their short-term fears for the single year, where they cannot see the terrible long-term cost of active funds’ higher fees.

Rodc suggested the right label for standard deviation: “standard deviation.”

Why do you feel a need to change its label to some word that eliminates specification of what it is, in favor of greater deceptive emotional impact. Why??

Dick Purcell

User avatar
magician
Posts: 1568
Joined: Mon May 02, 2011 1:08 am
Location: Yorba Linda, CA
Contact:

Re: Risk vs uncertainty

Post by magician » Thu Dec 29, 2011 4:40 pm

Fallible wrote:To me, risk in and of itself and by its definition, is negative.
Some people (probably the majority of those who bother at all) define risk to include only negative possibilities; others define risk to include both negative and positive possibilities. Which definition you use isn't particularly important; i.e., both are eminently workable. Knowing which definition you use (and which the people with whom you're talking / working use) is vitally important.
Fallible wrote:What can be positive is when risk is understood and dealt with properly to minimize its negativity.
In my work in project risk management I frequently find that managers have a hard time identifying true opportunities: most often, they see a potentially negative event, and then identify the response to that event as an opportunity. ("If steel prices rise we could end up overrunning our budget, but we have the opportunity of avoiding those price increases by entering into futures / forward contracts." No, the risk is the threat of higher prices. The strategy to handle that risk is to transfer it to someone else by using financial derivatives. There is no opportunity.)
Simplify the complicated side; don't complify the simplicated side.

Post Reply