Why Mr. Market looks differently at risk and uncertainty

The difference between risk and uncertainty

Published on:
January 25, 2020
Reading Time: 3 Minutes
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

It was in Risk, Uncertainty, and Profit, that economist frank Knight first observed the difference between risk and uncertainty. Knight saw the two words are different. He writes: 

The essential fact is that 'risk' means in some cases a quantity of susceptible of measurement, while at other times it is something  distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is present.

He continues: 

It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.


The difference between risk and uncertainty

Risk relates to what we can measure. And we measure risk with probability and relative frequencies. For example, when we hear in the news that 'there is a 50% chance of showers tomorrow', the anchor is expressing a form of risk management. 

Another example is in the medical profession when we hear that '9 of 10 patients recover from the common cold within seven days." It is worthwhile to note that measuring risk is neutral. It can refer to positive or negative events. 

Uncertainty, however, refers to unknown prospects. That is, to outcomes that cannot be understood from experience. The classic example of why the use of risk analysis in futile in an uncertain world is that of the Turkey illusion [1].


Mr. Market's view of risk and uncertainty

But Mr. Market [2] understand risk differently. To Mr. Market, how volatile the price of a stock defines riskiness. All else equal, if stock ABC goes up and down in price while stock XYZ's price is invariably the same, the market deems the latter stock safer than the former. 

Mr. Market also understands risk as a crucial reason for return [Akin to 'no pain, no gain]. With a mindset of 'no risk, no return.'  Also, the investment management profession, through ideas, such as the 'beta' [3] you can reduce risk by negative beta stocks. 

So often, the stock of these companies, especially when fear of recession looms, becomes expensive [4]. In sum, whether we agree or not, Mr.Market has dealt with the definition of risk.  

But Mr. Market refuses to deal with uncertainty. When Wall Street analysts are uncertain about the financial picture of a company, they cannot explain the prospects of the company. And when they cannot identify future outcomes, let alone quantify them, it is impossible to measure the risk the investor will take. And this inability to gauge risk reduces our confidence in their recommendations.

Mr. Market becomes even more worrisome when the uncertainty expands to the macro-level when interest rate guidelines are fuzzy. Or when little is communicated about the foreign policy. Or when there are factors such as geopolitical tensions and trade wars, the prices of publicly-traded businesses drop. 

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How auction-driven markets price uncertainty

You rarely buy a house, and after a month of ownership, someone offers you 40% more or less than you paid for it. Real estate, for the most part, is an open marketplace, with relative ease in comparing the price you pay to the value you get. 

But in auction-driven markets [5], mispricing happens more often than you think. I believe the confusion in the definition between risk and uncertainty is the main reason why you can buy a dollar for 40 cents in the stock market.


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I suggest reading TEVA's annual report for a current example of the difference between risk and uncertainty. Here is a shortlist of the uncertainty TEVA faces: 

Price-matching lawsuits, lawsuits for the U.S opioid crises, a considerable debt burden as a result of an M&A-gone-bad. TEVA is also in the midst of restructuring plan and turnover in executive management. 

But I bought a few TEVA shares nonetheless. Over the next few weeks, I will write in greater depth about the risk and uncertainty of TEVA. Write to me if you would like to be notified when I upload these essays. 

FOOTNOTES: [1] The belief that every problem should be solved with probability theory. [2] A euphemism of the stock market by Benjamin Graham. [3]The sensitivity of the stock to the market[4] Campbell soup, for example. [5] a market in which buyers indicate the highest price they are willing to pay and sellers indicate the lowest price they are willing to accept.
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