Risk And Uncertainty

In trading, people tend to use the terms risk and uncertainty interchangeably. But in the 1920s economist Frank Knight made a distinction.1 He argued that risk describes a system where we don’t know the outcome, but we do know what the underlying probability distribution of outcomes looks like. So think of a roulette wheel—when the croupier spins the wheel, you don’t know where the ball will land, but you do know all the possibilities and their associated probabilities. Risk also incorporates the notion of harm—that is, you can lose.

In contrast, uncertainty reflects a situation where you don’t know the outcome, but you also don’t know what the distribution of the underlying systems looks like. Uncertainty also doesn’t necessarily imply harm, although it often does. So it’s not hard to see that most systems we deal with in the real world are really uncertain, not risky. Uncertainty better describes issues like terrorism or the avian flu, or even markets.