28/4/2024 ☼ not-knowing ☼ risk ☼ uncertainty

I periodically remember that I’ve not posted anything easily and freely available about why formal risk and true uncertainty are not the same thing. The text below is mostly taken from chapter 5 of my book, *The Uncertainty Mindset*. The first two sections are verbatim, and I’ve modified the third section to make it clearer as an extract.

This is the tl;dr visual:

Explaining the difference between formal risk and true uncertainty is easier when they are contrasted with certainty.

In a certain world, you have all the knowledge necessary to know exactly how the future will be. Certain worlds are easy to describe, as the following scenario illustrates.

Certainty.Suspend disbelief and imagine that you are a U.S.-based manufacturer of a carbonated drink. You are sure that demand for your product will grow steadily at four percent a year. You own your manufacturing and distribution facilities, have long-term price contracts for all the materials you use to make your products, and have no desire to introduce new products. Current regulations also mean that you can be sure no competitors will enter the market. In this world, your business decisions — such as how much and when to invest in equipment, when to hire production staff and how many of them to hire — are straightforward and easy to analyze and plan for.

This scenario sounds almost caricature because such absolute certainty is nearly unheard of. We live in worlds that are uncertain in that we don’t know (and often cannot know) enough to be sure about how the future will work out.

The future can be unknown in different ways, because different types of unknown-ness are possible. Risk represents one of these types of unknown-ness, in which the world is not completely known but is fundamentally knowable.

Formal risk.The world of complete certainty described above remains except for one detail. There is now a chance that bad weather affects harvests in the countries where your sugar producers are located. If this happens, even with long-term price contracts, there is a chance that some of your sugar suppliers will be unable to deliver as much sugar as you will need. Specifically, your infallible analysts have put the chance of a 1,000-ton sugar shortfall at 20 percent within the next two years. Your production will be affected by such a shortage, reducing profit in that period by $2 million. Given current sugar prices of $220/ton, you protect yourself by buying 1,000 extra tons of sugar for $220,000 and renting additional warehouse space to store it for two years at $24,000. The risk here is the 20% chance of losing $2 million in profit in the next two years (i.e., $400,000), which exceeds the cost of buying and storing the emergency sugar stockpile ($244,000). Deciding to stockpile some sugar is clearly sensible.

“Formal risk” here means that the exact future that will result is unknown, but the different possible futures are knowable in a way that allows you to plan by calculating how likely different possible futures are and taking clearly sensible actions based on those calculations. To be clear, this requires a type of certainty about the unknowns (in this case, being certain that there is a 20% chance of a 1,000-ton sugar shortfall in the next two years). In other words, risk is a type of uncertainty that can be measured, quantified, then eliminated by a calculated strategic action (in this case, by stockpiling sugar).

True uncertainty is a different form of uncertainty from formal risk. Uncertainty cannot be measured and cannot be eliminated using strategies chosen based on likelihoods of outcomes.

True uncertainty.The world is again slightly different. This time, you’re uncomfortably aware that no regulations prevent competitors from entering the market and introducing new drinks that will compete with your product. You’re profitable, but not so profitable that you can be certain competitors will enter the market attracted by those profits. But you’re aware that competing products that do enter the market will probably affect not only how much you sell but also how much you can charge. However, you’re not sure how likely this is or how it will affect your business. Your company’s exact future is unknown, but you know neither all of the possible futures nor how likely each of those possible futures is. You aren’t able to calculate how likely the different possible futures are (as you could in the risk scenario) and make sensible decisions about what you should do based on such calculations.

In fact, this third scenario introduces only one element of uncertainty — whether another company will introduce a competing product into the market. Realistically, in a complex and interconnected world many other things are likely to happen to your soft drink company that would make its future difficult to foresee and thus to plan for.

The scenarios above show that certainty is easily understandable, and that things get confusing when they are un-certain.

Confusion arises because anything that is not certain (the first scenario above) is un-certain — but formal risk (the second scenario) and true uncertainty (the third scenario) are two forms of un-certainty that are actually fundamentally different from each other.

In formal risk, you don’t know exactly what will happen, but you know almost everything about what you don’t know: all possible actions you could take, all possible outcomes that could result, accurate probabilities connecting actions with outcomes, accurate and stable relative valuations of different outcomes. Knowing all this is what allows formal risk to be mathematically calculable, which is what allows it to be managed by managing expected outcomes.

In true uncertainty, you are missing crucial information about actions, outcomes, causation, or valuation. This missing information makes it impossible to accurately calculate expected outcomes and what they are worth.

Though formal risk and true uncertainty are often conflated, the scenarios above highlight how true uncertainty represents a fundamentally different type of unknown-ness than formal risk. Truly uncertain worlds are unknown in ways that make it impossible to decide how to act based on calculations that can be done in advance. True uncertainty thus has quite different implications for people and organizations compared to risk.

Where a situation is truly uncertain, believing it to be formally risky is to believe in a form of false certainty and to be, in a real sense, deluded about the state of the world. It is perilous to mistake true uncertainty for formal risk.