What is the difference between a measurable risk and an unmeasurable uncertainty? It was back in 1921 that economist Frank Knight differentiated between these two. Being a supporter of the notion that humans are inherently unpredictable, he distinguished risk from uncertainty. The former you can measure while the latter, you can’t.
Investors and the investment industry tend to ignore uncertainty. When investing, we’re aware that there are risks involved, but we are able to measure and mitigate against these risks. However, when uncertainty enters the picture, we’re suddenly lost. Our response is then to avoid uncertainty and run in the opposite direction. It’s called “ambiguity aversion”.
In 1961, Daniel Ellsberg performed an experiment whereby he set up two urns, both of which contained 100 balls. The first urn had 50 black and 50 red balls, whilst the second urn had a combination of black and red balls (an unknown probability, oh dear – uncertainty). Participants in the experiment were asked to select which colour ball they wanted to pick and out of which urn they wanted to pick it. The participants were found to be more inclined to pick from the first urn, which had 50 black and 50 red balls. This creates a paradox.
The majority of participants chose the first urn with the reasoning that it was less risky. But this isn’t so – the probability of selecting a red ball in the first urn is exactly the same as in the second urn. The risk is identical, but what is different is the uncertainty. As humans, we prefer the defined risk, that is, 50 per cent chance of picking a red ball in the first urn, to uncertainty. We take the “safe” choice.
Even experienced investors battle to see the onset of uncertainty. The stock market collapse of the 1970s with the advent of corrupt leaders, oil supply worries, etc, gave birth to the development of risk management models. But the irony is that these models cannot capture uncertainty and consequently add to the problem that was already there.
I am generalising, though … There are people out there that will choose uncertainty as they see the opportunity in uncertainty and take advantage of it. Entrepreneurs, in particular, have been found to be much less worried about operating in conditions of uncertainty. Although it might just be their overconfidence coming in to play (I’m speculating), which brings about other drawbacks which I discussed in last month’s article.
The future is uncertain and we can’t necessarily predict or control what is going to happen. But isn’t that what makes it half the fun?
Author: Gizelle Willows CA(SA) MCom Finance is a Senior Lecturer in Financial Reporting at the University of Cape Town