What is Risk?

The following are the definitions of risk according to the dictionary

• A situation involving exposure to danger
• The possibility that something unpleasant or unwelcome will happen
• A person or thing regarded as a threat or a likely source of danger
• A possibility of harm or damage against which something is or needs to be insured
• A possibility of a loss…..ex financial loss

What is Uncertainty?

Many people, including me, have used risk and uncertainty interchangeably. But, if you did deeper, they are different. The dictionary definition of Uncertainty is:

• The state of being uncertain
• The state of a lack of certainty

Possible Outcomes and their odds of happening

Let us consider some math now. Consider all possible outcomes of an event like rolling two dice. Listed below are all possible outcomes:

• (1,1)(1,2)(1,3)(1,4)(1,5)(1,6)
• (2,1)(2,2)(2,3)(2,4)(2,5)(2,6)
• (3,1)(3,2)(3,3)(3,4)(3,5)(3,6)
• (4,1)(4,2)(4,3)(4,4)(4,5)(4,6)
• (5,1)(5,2)(5,3)(5,4)(5,5)(5,6)
• (6,1)(6,2)(6,3)(6,4)(6,5)(6,6)

Any time anybody in the world rolls a dice, the outcome *WILL* be one of the above 36 possibilities. In addition, we can also assign odds to each of each of the possible outcomes happening. For example,

• The odds of getting a 2 is 1 out of 36 possibilities 
  • (1,1) is the only way
  • i.e. its PROBABILITY = 1/36 = .028 OR 2.8%
• The odds of a getting a 7 is 6 out of 36 possibilities
  • (6,1), (5,2), (4,3), (3,4), (2,5), 1,6)
  • I.e. its PROBABILITY is 6/36 = .17 OR 17%

Uncertainty Redefined

There are two kinds of uncertainties (credit goes to Frank Knight, author)

1. Type 1:  
   1. We know all the possible outcomes of an event in advance
   2. We may even know the probabilities of each of the outcomes i.e the odds of each outcome happening.
   3. This type of Uncertainty is called RISK.
   4. In the dice example above, we do not know that the possible outcome of a dice roll will be, but we know all the possibilities and their odds and we can plan/bet on them.
2. Type 2
   1. We do *NOT* know the possible outcomes….let alone their probabilities.
   2. This type of Uncertainty is called GENUINE UNCERTAINTY

Risks and Genuine Uncertainty….Example 1

Two examples of genuine uncertainties that I have personally faced are

1. 2008 recession
   1. Almost nobody even thought that such an outcome was possible for the US economy.
2. Private companies
   1. I used to work for a private/startup company…we had identified all possible outcomes:
      1. Go ipo: low probability
      2. Get acquired by a bigger company: High probability since many senior management folks came from the bigger company which was supposed to acquire our company
      3. Competitor: very low probability…we were in a new area and had a super headstart
      4. Etc etc
   2. But a competing startup company came out of stealth mode…a company we did not know even existed. Even more surprisingly the bigger company acquired them *the next day*….and an inferior product to boost. And our company self-destructed….all in the space of 6 months. 
   3. This outcome was not identified and had no probability associated with it.

Risks and Genuine Uncertainty….Example 2

Let us take the example of an ordinary economic recession vs the super duper recession of 2008.

 

• Ordinary Economic Recession

 

• • The possible outcomes (risks) of such an event can be
    • Possible job loss
      • Probability: 20%
      • Things to plan for:
        • An emergency fund lasting 6 months….done
        • Life insurance out of work…..done
        • Network with people and keep track of which companies are healthy and hiring
    • Possible portfolio loss
      • Probability: 80%
      • Things to plan for:
        • As long as there is no need to withdraw cash, keep investing and dollar cost average down. 
        • If already in retirement and drawing income or cash from portfolio, then keep a larger emergency fund to cover atleast 2-3 years of annual expenses in cash

 

• 2008 super duper recession

 

• • I did not even dream of such a possibility….just like most of the world’s top economists 😐
    • My portfolio went down 40-50% and I had a conservative portfolio
    • I barely retained my job…but I knew many people who not only lost their jobs but could not get one for another 2 years, went through divorces, and many other hellish scenarios.
    • What if you are already in retirement and drawing money from the portfolio? Withdrawing money when the portfolio is down 30-60% is suicide 😦 

Should we plan for Genuine Uncertainties at all?

By now, we have understood the differences between Genuine Uncertainty and Risks. 

• Risks can be anticipated because there are a set of possible outcomes. Since the outcomes are known, they can be mitigated by planning. Impact is reasonable.
• Genuine Uncertainties cannot be predicted and hence there is no way to have a set of possible outcomes to plan for. Impact is very high.

If genuine uncertainties are so rare, then should we plan for it at all? In my personal experience, I have found that the genuine uncertainties are increasingly becoming frequent in the last two decades.

• Finance:
  • In the last 2 decades, we have seen multiple instances of such unpredictable events in the financial world….2001 dot com bust, 2008 great recession, 2016 election night drop, etc
  • One impact example. I know people who were forced to go through home short sales and take a drastic cut to their standard of living: all cases were induced by job losses.
• Health:
  • In my social circle, I have lost two people in an instant…heart attack and cancer…how do we deal with such unpredictable events in the personal world?
  • Work stress was the main cause in both. But one of them had reasonable savings and the family got taken care of. The other was a bit of a mess. 
• Relationships:
  • A close friend got divorced…mainly (imo) due to the pressures induced by two unpredictable events in the finance world
  • A couple of families relocated out of this HCOL area…again due to pressures of the economy.

Going by what I am seeing in the last two decades, planning for Genuine Uncertainties is not an option anymore. WE HAVE TO PLAN FOR IT!

Possible Solutions for Genuine Uncertainties

We will talk about two solutions in a subsequent blog post.