July 9, 2014

Risk and Uncertainty

Nate Silver’s book, The Signal and the Noise, is on its way to join my all-time favorites, alongside both of Michael Lewis’s The Big Short and Liar’s Poker.

I’ve been experimenting with the application of expected value in different fields of life, and the distinction between risk and uncertainty — often used interchangeably — is definitely important in this context:

Risk, as first articulated by the economist Frank H. Knight in 1921 is something that you can put a price on. Say that you’ll win a poker hand unless your opponent draws to an inside straight: the chances of that happening are exactly 1 chance in 11. This is risk. It is not pleasant when you take a bad beat” in poker, but at least you know the odds of it and can account for it ahead of time. In the long run, you’ll make a profit from your opponents making desperate draws with insufficient odds.

Uncertainty, on the other hand, is risk that is hard to measure. You might have some vague awareness of the demons lurking out there. You might even be acutely concerned about them. But you have no real idea how many of them there are or when they might strike. Your back-of-the-envelope estimate might be off by a factor of 100 or by a factor of 1,000; there is no good way to know.

Regarding the latest financial recession, Silver concludes:

The alchemy that the ratings agencies performed was to spin uncertainty into what looked and felt like risk. They took highly novel securities, subject to an enormous amount of systemic uncertainty, and claimed the ability to quantify just how risky they were. Not only that, but of all possible conclusions, they came to the astounding one that these investments were almost risk-free.
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