CHAPTER 9How to Assess Risk

The Difference Between Risk and Uncertainty

On Wall Street, risk and uncertainty are often used interchangeably, although, as we discuss below, they are not the same thing. That fact is apparent if one simply looks at the definition of each term in the Merriam-Webster dictionary:

  • Uncertainty: Something that is doubtful or unknown
  • Risk: Possibility of loss or injury

We illustrate the difference with a simple story:

Your grandmother gives you a lottery ticket as a birthday present.1 It is impossible to know if the ticket is a winner before the lottery is held. There is uncertainty to the outcome, but no risk because you have nothing to lose.

Next, assume that you buy a $2 ticket for the same lottery. In this case, there is uncertainty AND risk. The uncertainty is the same as with the ticket your grandmother gave you, but there is now the possibility of losing the $2 you paid for the ticket. The lottery ticket you purchased has financial risk because of the very real possibility of losing money.

As the example demonstrates, because uncertainty has no harm associated with it, there is no risk. It is only when an investor commits capital to an uncertain outcome that he is exposed to risk.

Merriam-Webster defines uncertainty as “something that is doubtful or unknown.” It is critically important to note that uncertainty is not necessarily bad and in many situations can be good.2 In general, however, humans crave certainty and hate uncertainty. Certainty ...

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