Understand the difference between risk and uncertainty while investing

Risk and Uncertainty, almost sound like synonyms. Same – same but different so they say. Investors do get confused between the two as they seem similar and when it comes to trading or investment there is always an element of Risk and Uncertainty.

Risk in Financial Markets

Risk in the context of Investing is something that can be foreseen. Risk is a potential for loss. Risk has both positive and negative aspects to it and is seen as a potential loss against probable profit. A company with a higher degree of risk will have a lower Price – Earnings ratio, conversely, to earn higher returns, one has to take risks. Higher risks will not necessarily translate to higher gains though.

The redeeming factor is Risk can be quantified. Every investor can enter a Trade or Investment fully aware of the risks involved which will enable him to pull out if it isn’t going his way.

In summary, Risk is the probability of a loss or a profit not happening.  If a company makes less profit than it should have that’s a risk. Risk is relative to expectations as far as financial markets are concerned. Broadly risks are classified into two types: Systematic risk and unsystematic risk.

Systematic Risk – Is the risk that is integral to the market and subsequently the economy as a whole. This risk cannot be predicted and it affects all businesses. It can only be avoided by hedging or asset allocation strategy

2008 Housing Market collapse and the recession that followed in an example of Systematic Risk. Most markets could just look on while the stocks of each sector were falling freely.

Unsystematic Risk – is specific to the company or Sector. The investor can reduce the risk by diversifying the portfolio hence Risk can be managed.

Losses caused due to Labor issues, reputation problems, lack of entrepreneurial judgment are some examples. This is limited to a company or a sector at the most.

How is Uncertainty different?

Uncertainty, the absence of certainty. Illness, natural calamities, regime change are examples of uncertainty. Uncertainty cannot be measured or quantified hence uncertainties can only be insured.

The difference is best explained with an example of Cricket. Team India is going to be announced for the World Cup 2023. We have followed each player and team closely through the years leading to 2023 and are fairly sure about the consistently performing players that will be selected.

Would you bet on Team India knowing the squad? Very likely. That’s a Risk for you

Would you bet on Team India not knowing the players until they enter the field for the first game? Most won’t, in fact, all.  That’s uncertainty.

Key differences between risk and uncertainty:

• Risk is measurable uncertainty whereas uncertainty is an immeasurable risk. What can be measured can be managed. What can’t be measured can be insured. Risk can be managed using Historical data and Mathematical formula indispensable to financial markets.

• Risk and Uncertainty relate to the same concept of – Randomness except that Risk is measurable

• We can assign probabilities to risks events not so much with uncertainty

(Standard Deviation  – Value at Risk – Beta (Assets Return to an Index) are some examples of Historical Data and measurement tools to arrive at probable risk)

• Scale of Uncertainty cannot be gauged until it happens hence the classification is generic Natural calamities etc but Risk is divided into Systematic and Unsystematic Risk which can be divided into high and low risk. Diversification is the key took an investor should use for managing unsystematic risk. Systematic Risk can be managed by hedging one’s portfolio.

(Government announcing the reduction of its stake in PSU’s is an example of unsystematic risk. Changes in laws is an example of Systematic Risk)

• Life is inherently uncertain and this uncertainty is integral to Insurance. Loss of Life, ill health, natural calamities, social unrest, etc. The premium you pay for insuring is to protect you in the aftermath of uncertainty. Risk cannot be insured.

(Life Insurance, Mediclaim, Travel Insurance, Fire Insurance are examples of Insurance in terms of uncertainty)

These differences between Risk and Uncertainty are important for an investor to protect himself from unnecessary risks or unforeseen circumstances.