Making decisions, life or financial, bear a certain amount of risk as well as the uncertainty of the variable outcomes inherent to those decisions. The risk of arriving at a negative outcome can be measured while uncertainty is defined by the stretch of the unknown. Decisions are based on forecasts or expectations of different outcomes. All forecasts are subject to uncertainty and the goal of successful forecasts would be for the outcomes to fall within the pre-defined confidence levels. The goal of making financial decisions on your investments and assets is to arrive at positive outcomes where having the ability to properly understand and measure the risks hedging uncertainty is paramount for the appropriate management of Finances.
Risk and uncertainty can be clearly distinguished. Risk is quantifiable while uncertainty is not. The risk applies to random outcomes that an investor can model with known probabilities while uncertainty presents random outcomes with unknown probabilities. An investor may be left paralyzed when faced with significant uncertainty that may have a large impact. Those situations have to be identified early and hedged appropriately. This is very important as tail-risk events of very low probability but very high impact can sometimes wipe out months of gains and bring businesses down to the knees if not hedged and discounted for. The opportunity cost of foregoing one action for another despite its probabilities can arise fear of inaction and it’s a cost that may exceed the costs of taking unknowable risks. This is only one specific example of risk from a pool of many others that depend on the type of assets and investments at risk. Risk & uncertainty are based on the asymmetry of information that an investor has that leads to the probabilities and certainty of the outcomes.
Risk allows the use of mathematical models to aid in the decision making process as the probabilities of different outcomes can be estimated through probabilities analysis by finding the distribution of outcomes and the calculation of the expected values. While statistics can be used to find the appropriate confidence intervals and define probabilities, uncertainty can be modeled through the use of sensitivity analysis and simulations such as Monte Carlo. Sensitivity analysis takes each uncertain factor in turn, and calculates the change that would be necessary in that factor before the original decision is reversed. One limitation of this analysis is that it only identifies how far a variable needs to change; it doesn’t look at the probability of such a change. Monte Carlo simply uses a stochastic numbers to test different scenarios that a particular decision may lead to. Finally, the use of decision trees is useful when we have a clear course of outcomes present.
In the Financial markets, the Capital Asset Pricing Model is used to measure the market risk and uncertainty. As investors take in more risk they expect higher returns. The efficient frontier is the place where investors put in their money for the limited amount of risk gaining optimum return. To shift return out of a portfolio of securities diversification helps to optimize the risk/return profile. To measure the market risk/systemic risk the Greek Beta is used. A risk free security carries no risk and a Beta of zero. Market portfolio beta is 1 where the portfolio of stocks follows the market like the S&P500 to return the optimally. Beta greater/lower than 1 indicates the volatility and risk of the particular portfolio. It is often assumed that the optimal diversification to reach returns at the efficient market frontier is 25 while adding anymore securities doesn’t necessarily reduce the market risk. The unsystematic risk represent the general uncertainty within the markets that can’t be measured. CAPM assumes perfect capital markets, unrestricted borrowing and lending at the risk-free rate of interest. It provides a market based relationship between risk and return. There are some limitations to CAPM as it only concentrates on systemic risk while other aspects of risk are excluded. Moreover, the model only considers only the level of return as important to investors not the way in which that return is received that being through dividends or capital gains. The unsystematic risk represent the general uncertainty within the markets that can’t be measured. Good way to make sure investor protects themselves from that type of risk is through hedging it. There are different financial instruments like options, forwards, swaps, exotics that can be used. Finally, investors need to stay on top of the risk in their portfolios at all times and this can be easily monitored by monitoring the investor’s portfolio Sharpe Ratio and draw-down levels. Investor’s relationship with risk is as important or if not more important than the search for higher returns.