It is common for investors to make decisions under risk and uncertainty but sometimes they forgot that risk and uncertainty are two different things in the investment market. In reality, both are completely differenced concepts which need deep understanding while making investment based decisions. To get the better understanding of risk and uncertainty and differentiate one from another, we will help you through this guide where you can understand the key differences between risk and uncertainty. Or more specifically, what do both terms imply for stock market investments?
Risk is the Potential for Loss…
Yes! Risk can be understood as the potential for loss. So, is that it?
Well, risk has many definitions. But, what we’re interested in is to know about the risk in the financial markets. According to Frank Knight, Economist of Meaning of Risk and Uncertainty (1921), “Risk is randomness in which events have measurable probabilities”.
In the financial markets, the risk is something that involves exposure to danger. Here, this exposure could be of a financial asset that matters. It is because it can be measured, understood, and managed. In the stock market, the risks are classified into two categories: systematic and unsystematic risk. Systematic risk is the market level risk that impacts all businesses equally. The beta of the stock used to measure systematic risks. Interest rate decisions, rising trade deficit, higher inflation, and political uncertainty are some examples of systematic risk factors.
However, the unsystematic risks are specific to a company or a sector. Tough competition and weak margins are the examples of unsystematic risks.
So, in a nutshell, we can say that risk is something that can be measured based on past experience.
What exactly is Uncertainty, then…?
As the name suggests, it is the state of being uncertain. In simple words, uncertainty reflects a state or situation where you are not sure of future outcomes. Thus, unlike risk, it becomes difficult to measure the uncertainty since the outcome is uncertain. For instance, Guwahati is the level 5 seismic zone of India and highly prone to earthquakes. But, you can’t say that there will be an earthquake in Guwahati in the next 5 years. Since the event itself is uncertain, the outcomes also become uncertain. So, try to use ‘possible’ with respect to uncertainty and ‘probably’ with respect to risk.
Key Difference Between Risk & Uncertainty
Now that you’ve understood the concepts of risk and uncertainty. It is time to see the differences between them. From the above, we came to an understanding that risk is a measurable uncertainty while the uncertainty is an immeasurable risk.
From investment management point of view, risk matters since it can be measured; understood, and managed. Let us take the case of a portfolio with systematic and unsystematic risk. The systematic risk can be managed by beta hedging against Nifty Futures. On the other hand, the unsystematic risk can be managed by diversifying away from stocks and sectors. But, the uncertainty cannot be measured. That’s why it cannot also manage. But, it doesn’t mean you cannot do anything. You may not control or manage uncertainty but you can have insurance against it. There is no insurance against risk but with uncertainty, it certainly does!
By taking a look at the above chart, it is clear that when the probability of occurrence of an event is certain, then the possibility of managerial control is high and the possibility of failure is low. But, when the probability of occurrence of an event is low, then the possibility of failure is high while the managerial control over the event is very low. If you noticed, the risk is between these two – it means that there is still some uncertainty over the occurrence of an event. But, the probabilities can be assigned and managerial decisions can take accordingly.
- The risk is a state of winning or losing something worthy however uncertainty is a possibility of some future event with no knowledge.
- Since future events are unpredictable so it can’t be measured by quantitative models but risk matters so it can be measured and quantified.
- The outcomes are known in risk but in uncertainty, the outcomes are unknown.
- The risk is controllable and if takes necessary measures and precautions. But, the uncertainty is beyond the control, as the future is uncertain.
Hope, you get all the necessary information you were looking for. Nevertheless, if you have any query or would like to add something then don’t forget to mention in the comment section below.