FAP621: Economics 101: Risk Can Be Managed – Uncertainty Cannot, Bree Noble

One of my favorite podcasts to listen to is Bloomberg on the Economy, published by megalithic financial services company Bloomberg LP. It’s a great, often dense series of interviews with prominent economists, public figures, etc. Recently, Jacob Frenkel of insurance giant AIG had an insightful way of talking about risk.

Risk is a probability of something happening, and then your ability to deal with that risk. There is always a probability of rain, as an example. Some days, that probability is very close to (but never) zero. Some days, that probability is close to 100%. Which end of the risk spectrum of rain determines whether you carry an umbrella. Whether you choose to carry an umbrella or not is your comfort with risk vs. opportunity cost. If you’re incorrect at judging risk conservatively (10% chance of rain? Holy cats, it’s the Great Flood!), you carry an umbrella on days when you don’t need it. If you’re incorrect at judging risk aggressively (90% chance of rain? But it never rains on Wednesdays!), you get rained on more often than you should.

Frenkel points out that risk is entirely manageable, and therefore subject to rational thinking. Generally speaking, risk is expressed in the form of a percentage. If you say something is risky but can’t express it in terms of a percentage, it’s probably not a risk, or you’re uncertain.

Uncertainty is a different animal. Uncertainty is when you don’t know what the risk is – you simply have insufficient data. Again, with the weather, if you don’t listen to the forecast and you don’t look out the window, judging the risk of rain is a great deal harder to do. It’s much easier to make poor choices with a lack of information, and therefore uncertainty is a dire enemy in any situation in which you have to assess risk. Uncertainty can also come from poor quality data, or data that is irrelevant. Ed Roberts’ Kansas City Weather Podcast is extremely poor quality data – if you live in Boston, as I do. It’s great for assessing risk in Kansas City, but it just creates uncertainty in Boston.

When you’re considering whether to make a move or not, whether to quit a job or not, whether to make a choice or not, ask yourself – are you making a rational choice based on risk, or are you taking a shot in the dark because you’re uncertain?

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