The terms risk and uncertainty are frequently used synonymously. When it comes to investments, even investors frequently confuse risk and uncertainty. There is a huge distinction between the two of them. Without recognizing it, we frequently make investment decisions under risk and uncertainty. It is crucial to understand the distinction between risk and uncertainty in investments, as well as their example.
Risk is a circumstance in which we are aware of potential outcomes, such as A, B, or C, but we do not know the precise result. Consider making a stock market investment with the possibility of making a profit, a loss, or break even. Until we make an investment, we cannot predict which of the outcomes will come to pass.
Risk is important from the perspective of the financial markets since it can be quantified, comprehended, and managed. Financial markets typically divide risk into two groups, namely systematic risk, and unsystematic risk.
Systematic risk is a market-level risk that has an equal impact on all firms. In stock markets, we use the stock’s beta to calculate the systematic risk. There are also unsystematic risks that are unique to a business or industry. Strong competition and thin margins are two instances of unsystematic risks. So, to summarize, risk is something that can be assessed based on prior knowledge.
Uncertainty, as its name implies, is the absence of certainty. The outcomes also become uncertain because the event itself is unpredictable. Since the results are uncertain, defining or measuring uncertainty becomes necessary. Therefore, uncertainty refers to a circumstance in which you are unsure about the outcomes. We use the word possible with respect to uncertainty and probably when it comes to risk because you can assign probabilities to outcomes based on experience.
Having grasped the idea, let’s examine the main distinctions between risk and uncertainty.
Differences between risk and uncertainty
The difference between risk and uncertainty is best explained as “Risk is measurable uncertainty while uncertainty is an immeasurable risk”. Simply put, risk can be considered as a subset of uncertainty that is quantifiable or measurable. The extreme component of risk that is immeasurable and therefore unquantifiable is uncertainty.
Uncertainty denotes a situation where future events are largely unknown. Since the events are unknown, the outcomes are also unknown. Since the outcomes are unknown, it is hard to assign probabilities to the possibility of occurrence. Effectively, this makes it hard to measure and assign a probability. Risk, on the other hand, refers to a future event that can be known with a reasonable degree of certainty. While the actual event is still unknown, you can assign probabilities to the occurrence of various possibilities based on experience. That is what makes risk measurable and manageable.
From an investing perspective, risk can be managed. Consider a portfolio containing both systematic and unsystematic risk. By diversifying away from stocks and industries that are struggling, the unsystematic risk can be controlled. Similarly, systematic risk can be reduced or controlled by beta hedging against the future. However, uncertainty cannot be measured, and as a result, it cannot be managed