Monday, June 14, 2010

Known, unknown, and unknowable risks

We are all taught what is known, but we rarely learn about what is not known, and we almost never learn about the unknowable,''

Ralph E. Gomory, the president of the Sloan Foundation, wrote in Scientific American in 1995.

I have been reading research on the risk management topic of the known, unknown, and unknowable. This has been called by some, KuU risk. While there could be a better name, the concept is very important and seems to be a good extension of the Knight-Keynes distinctions on risk and uncertainty. There are risk that are know or knowable. This would be through actual experience. There are also risks which are unknown which are difficult to model or describe. There are also risk which we just do not known and are unknowable and unforeseen.

The market has gotten good at measuring known risks. This is best depicted as the volatility in price. We have data and can measure the width of the distribution. Almost all of the work of risk manages have been focused on this area. If you can measure and model it, it can be discussed.
Investors have not been as good at dealing with the "unknown" or risk which are difficult to measure and have done limited work at trying to protect gain the unknowable.

Education will be able to move some of the unknown risk to the known category. As we better understand the process of prices e can adapt to a world with fat tails and move away from Gaussian normal distribution. As some unknowable events occur like 9/11, we can place them in the context of the possible.

Still the unknown and unknowable risks are the ones which will create the largest problems for any investors, yet we do not have any tools to look at these issues.

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