1.2 Defining Risk
Learning Objectives
In this section we discuss the following:
The concepts of risk and uncertainty.
How to differentiate between risk and uncertainty.
That risk is a consequence of uncertainty.
Risk is all around us, exerting an invisible influence over the many decisions we make every day. But risks’ ubiquity does not make it an easy term to define. In everyday English the meaning of the word “risk” is often ambiguous. For example, when a businessperson says an investment is “too risky” for their company, do they mean the investment is too risky because of the amount of money that could be lost? Or is it too risky because, given the amount invested and the expected gains, the probability of loss outweighs the potential gains? Likewise, when an individual says: “I’m getting a flu shot because I can’t risk getting sick,” what do they mean by “risk”? Is it the danger that they might get the flu and miss work or school? Or are they making a cost-benefit analysis Process of comparing the potential costs and benefits of a decision., weighing the benefit of the flu shot (greater protection against the flu virus) against its costs (time to get the shot, cost of the shot, discomfort, chance of an adverse reaction)?
We often hear the word “risk” used to indicate “danger” or to refer to a negative event and/or outcome. But “risk” is not the same as a hazardous situation. Nor is risk necessarily negative. Risk offers opportunities for loss as well as for gain. When we make decisions, we consider both the negative and positive possibilities, weighing the probability (the chance for loss or gain) of an outcome against it’s potential benefit or cost. We make these calculations countless times every day, often unconsciously.
In this section we explore the meaning of risk within this decision-making context. At the core of our definition of risk is the concept of uncertainty.
Risk vs. Uncertainty
Risk is inextricably linked to the notion of uncertainty. But while uncertainty lies behind the definition of risk, they are not equivalent terms. Rather, risk is a consequence of uncertainty. We define uncertainty as follows:
UncertaintyAn event or situation with an unpredictable outcome (having two or more possible outcomes). is an event or situation with an unpredictable outcome.
In an uncertain situation we may have two or more possible results, but we cannot know the outcome ahead of time. Certainty, the flip-side of uncertainty, refers to knowing for sure that something will or will not happen. If we knew, without a doubt, that something bad was about to occur, we might call it apprehension or dread. It would not be risk, however, because it would be predictable.
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Examples of Uncertainty |
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Employment opportunities available when you graduate from college. |
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Not knowing if there is a speed camera on the road ahead. |
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Who might see your social media posts. |
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Whether the expired carton of milk in your fridge is still good to drink. |
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Is Airbnb (short-term rental of your home) a good idea. |
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The outcome of a game of cards. |
As these examples show, uncertainty can be positive or negative; uncertainty can create opportunities for gain and the potential for loss. Risk, is a consequence of this uncertainty. Each of the uncertain situations listed above have potential consequences, both positive and negative. Below we provide some examples of possible consequences (risks) deriving from these uncertainties.
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Examples of Risks Arising from Uncertainty | |
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Uncertainty |
Possible Consequences (Risks) |
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Post-college job market |
Finding or not finding a job in your chosen field after you graduate. Whether the tradeoff between college loans and increased income and/or career satisfaction was worth it. |
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Speeding |
Getting a speeding ticket, causing an accident; or not getting caught and arriving at your destination faster. |
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Social media posts |
Getting likes, retweets, and other positive feedback; negative feedback and online harassment; your personal information being shared with strangers; current or potential employers finding your social media posts. |
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Expired milk |
Drinking the milk (which still smells fine) and getting sick or not getting sick as a result. Throwing out the milk, not having any milk for your cereal, and being hungry. |
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Airbnb hosting |
Earning extra income vs. upfront costs; potential property damage caused by guests; noise by guests upsetting neighbors; local regulations restricting short-term rentals. |
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Card game |
Satisfaction from winning or disappointment at losing. Potential financial loss or gain if you bet money on the outcome. |
As with uncertainty, risk results in positive as well as negative outcomes (the possibility for loss as well as opportunities). While we typically associate “risk” with unpleasant or negative events, in reality some “risky” situations can result in positive outcomes. For example, starting a new business is often quite risky, with a high chance of failure. But the potential financial rewards can also be significant. This is why venture capitalists are willing to invest in unproven startup firms. In this case, the risk (potential financial gain or loss) is the consequence of the uncertainty of whether the startup succeeds or fails. But the consequences of uncertainty are not just financial. They may be non-economic (behavioral or psychological) as well.
Thus, we arrive at the following definition of risk:
RiskThe consequences (both positive or negative) of the lack of predictability of an event or situation that involves having two or more possible outcomes (uncertainty). is the consequences (both positive or negative) of the lack of predictability of an event or situation that involves having two or more possible outcomes (uncertainty).
The Role of Risk in Decision Making
In a world of uncertainty, we regard risk as encompassing both the opportunity for gains as well as the negative prospect of losses. Figure 1.2, a Venn diagram, illustrates risk-reward outcomes. For both individuals and enterprises, risk is a component of the general objective of maximizing the value associated with a risk. At the same time, we seek to minimize the possibility of negative outcomes (such as bankruptcy). The right circle of the figure represents mitigation of adverse consequences, like business failures. The left circle represents the opportunities for gains when risks are undertaken. As with most Venn diagrams, the two circles intersect. In this case, the overlap represents the set of opportunities for which people are willing to take on risk (left circle) for potential reward (right circle). The overlapping area is the set of opportunities which both minimize risk and maximize value.
Figure 1.2 Roles (Objectives) Underlying the Definition of Risk
Figure 1.2 can help you conceptualize the effects of risk. Risk permeates the spectrum of decision making from goals of value maximization to goals of insolvency minimization (in game theory terms, maximin). Here we see that we seek to add value from the opportunities presented by uncertainty (and its consequences). The overlapping area shows a tight focus on minimizing the pure losses that might accompany insolvency or bankruptcy.
Definitions of Risk
We previously noted that risk is a consequence of uncertainty—but it isn’t the state of uncertainty itself. To broadly cover all possible scenarios, we don’t specify exactly what type of “consequence of uncertainty” we are considering as generating risk; it may be an emotional consequence, financial consequence, reputational consequence, or physical consequence. In the popular lexicon of the English language, the “consequence of uncertainty” that constitutes what we refer to as “risk” is that there is a (generally but not always) negative impact resulting from the fact that the observed outcome deviated from what we had expected. We can plan for what we expect to happen. Deviation from what we expect can lead to risk, which we measure in Chapter 2 “Measuring Risk”. Consequences, you will recall, can be positive or negative. If the deviation from what was expected is negative, we have the popular notion of risk. “Risk” arises from a negative outcome, which may result from the unfolding of uncertainty (or an uncertain situation) in a manner that deviates negatively from the expected outcome.
Our perception of risk arises from our perception and quantification of uncertainty. In scientific settings and in actuarial and financial contexts, risk is usually expressed in terms of the probability of occurrence of adverse events. In other fields, such as political risk assessment, risk may be very qualitative or subjective. If we try to get an ex-post (i.e., after the fact) risk measure, we can measure risk as the perceived variability of future outcomes. Actual outcomes can differ from the outcome we expect. Such variability of future outcomes corresponds to the economist’s notion of risk. Risk is intimately related to the “surprise an outcome presents.” Various actual quantitative risk measurements are the topic of Chapter 2 “Measuring Risk”.
Key Takeaways
Uncertainty is a precursor to risk.
Risk is a (usually negative) consequence of uncertainty. Risk can be a negative emotional, financial, or reputational consequence associated with the realization of uncertainty.
Maximization of value and minimization of losses form a continuum on which risk is anchored. Usually achieving more return (value) from engaging in an activity involves facing the increased likelihood of risk, whereas minimizing the likelihood of losses involves being able to achieve lower potential value or return.
One consequence of uncertainty is that actual outcomes may vary (negatively) from what is expected and as such represents risk.
Discussion Questions
What is the relationship between uncertainty and risk?
What is the formal definition of risk?
Identify an uncertainty and consider the possible consequences arising from that uncertainty.