Risk and Uncertainty: A Useful Distinction

This blog entry from the Financial Times makes an excellent point about the distinction between risk and uncertainty. Sull notes that "People encounter risk when they face what I call a “clear choice,”  where an agent can specify, in advance the possible outcomes relevant to their actions. A gambler, for instance, knows that there are precisely 38 possible pockets where the roulette ball could land, and where the ball lands will influence whether his bet pays off or not."

On the other hand, "Uncertainty arises out of “messy situations,” where the variety of actions an agent could take to achieve her goals is nearly infinite.... The broader range of possible actions complicates the data required to inform action. In messy situations, managers cannot specify in advance all the possible states of nature that might influence their best course of action."

The difference is useful to keep in mind when making difficult decisions. In many cases, statistical, objective analysis is simply not available. The uncertainty will not go away. In such situations, soft factors such as judgment, experience, values, and fuzzy historical precedences may be the best information you can get. That's why you make the big bucks. Be humble but decisive, and keep gathering information on the consequences, adjusting if necessary along the way.

An example of the difference:

The relevance of outcomes is defined by the range of actions an agent can take to achieve her objectives. In clear choices, the range of actions is limited and well-defined–a fan bets or not–but mind-boggling in messy situations–the coach juggles countless interactions of trades, training, strategy and tactics to win. The following thought exercise illustrates the distinction between risk and uncertainty.
Imagine Warren Buffett goes to the mountain and God hands him a tablet with the correct probability distribution of possible market caps for Microsoft a decade hence. Assuming Buffett’s investment horizon is ten years, this information is most useful in deciding whether or not to invest. For Steve Balmer, this information is practically useless. He could quit of course, or buy more options based on the divinely revealed probability distribution. But if he decides to stay, he would need much more granular data on how competition, technology, regulation, macroeconomics and other factors might interact to create specific opportunities or threats. Only this more detailed information would allow him to take precisely the right actions in the right combination at the right time.