For example, some Bogleheads continue to espouse the distinction between risk and uncertainty that economist Frank Knight developed over 90 years ago. Knight’s definition of risk vs. uncertainty had been discarded by most of the economics profession by the 1940s, but apparently his definition still holds sway over many investment enthusiasts even today, over six decades after economists had rejected it.
In his new book on personal finance, Risk Less and Prosper, Zvi Bodie clearly and concisely states the standard economics definition of risk.
Page 50.Defining Risk
To start, we need to define what we mean by risk. To build your own insight, ask yourself what risk means to you, based on your own exposures to risks – financial or otherwise. 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 will 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.
Notice that the above simple standard definition of risk in economics encapsulates the two aspects of risk, often called the components of risk, that VictoriaF discusses in the other thread.
Consequences - how much the risk "matters"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."
Probability of occurrence - the degree of uncertainty the risk entails
Why risk, which is such an important and basic element of finance, continues to be so confusing to many people knowledgeable in general about finance and investments is puzzling. But how can we hope to effectively manage risk if we don't know what it is?
I also find it odd that people continue to confuse a method of measuring investment risk, standard deviation, with the definition of investment risk. It seems obvious to me anyway that a method of measuring a phenomenon is not the same thing as the definition of the phenomenon.