What is the difference between risk and uncertainty?

Risk is a situation where the likelihood of an event happening or not happening can be measured and quantified. The decision maker is aware of all the possible outcomes and the probability of each occurring. For example, if you engage in a game of throwing a die and you win only if you get a six, the likelihood of getting a six is known as 1/6 or 16.7% (the die has six numbered sides and each side has an equal chance of being shown). This is a risky situation as the likelihood of getting a six is known.

Uncertainty is a situation where the likelihood of an event happening or not happening is not known; the probability of the occurrence or non-occurrence of an outcome cannot be measured. Staking your money in a gamble without any idea of the possibility of the occurrence or non-occurrence of the outcome is an example of a situation involving uncertainty.

Many decisions or transactions we make daily are made under risk or uncertainty, e.g. gambling, investing in shares or bonds. For example, the return anticipated from an investment may be different from the actual return; this is a risk.

Attitude towards risk

The expected returns determine the attitude of an individual to risk; higher returns are anticipated for taking higher risk and vice versa.

The three types of attitudes to risk in a fair game are explained below. A fair game is one in which there is an equal chance of all the outcomes occurring and the expected value of the game is zero. For example, a person offers $4,000 as a bet on the toss of a coin. If a head is tossed, $4,000 is won; if a tail is tossed, $4,000 is lost. The expected value of the game is zero as each outcome has an equal chance of happening (50% each). The expected value  is calculated thus:

Expected Value = 0.50 ($4,000) + 0.50 (-$4,000) = $2,000 – $2,000 = $0

Risk Neutral

A person is risk neutral if he will play the game if the odds are favourable to him. He will always avoid a game if the odds are unfavourable to him. A risk neutral individual is indifferent to a fair game

Risk loving

A risk loving individual is ready to play a game even if the odds are unfavourable to him. He will play the game even if the gain from winning is less than what he will lose if he does not win.

Risk averse

A risk averse person will not play if the odds are unfavourable. He will not take part in a fair game; he will avoid it even if the expected return is very high as long as there is a high level of uncertainty. He prefers low risk and low return to high risk and high return. His priority is avoiding losing his money.

How to reduce risk

Insurance

Insurance can protect against the occurrence of future losses like theft, fire or death. Anyone who buys an insurance policy is compensated by the insurance company if a loss insured against occurs. However, periodic payments, called premiums, have to be paid to the insurance company.

Diversification

A business can spread risk by investing in different types of business. If it loses from one business, the others will fetch it money. Likewise, an investor can combine shares of companies from different industries because a problem or loss could be industry-specific. He would normally buy different kinds of stocks to reduce the risk of loss.

Forward market

It is a market where an agreement is made for the purchase of a good in the future at a price that is agreed upon now. For example, one party who wants to buy gold from another in six months may agree on a price now to protect against fluctuations in prices in the future.

Complete information

The lack of complete information is why we face risk in decision-making. When a business provides complete information about its product by advertising; its expected profit would be higher than if it does not provide the information. The value of complete information is the difference between the expected value when there is complete information and the expected value when there is no complete information.