Subway Versus Coconut Uncertainty

 

The current state of the art in risk management focuses on describing the types of uncertainty that exist or are faced. At a very abstract level, markets deal with two types of uncertainty and risks, those that are measurable and those that are truly uncertain and cannot be clearly measured.[1] Put differently, the two major types of uncertainty can be described through analogies with subways or coconuts. 

Subway uncertainties are predictable in the sense that we can form a distribution on the arrival time of any given train. There is a countable level of predictability about when the next train will arrive according to its schedule. Sample enough subway trains and we will have a good idea of on-time performance. Still, there are no guarantees and sometimes the train will be late or early, but you know what to expect within a set of bounds given this performance history. You can plan based on this predictability of variance.

However, life is not that simple. There are many events where you cannot form a distribution. You can imagine the event, but there is not any well-defined structure that creates predictability.The events are not countable in any meaningful manner. For example, coconuts are known to fall from trees, yet it is almost impossible to determine when or where they will fall. There is no predictability to these events, yet if you are standing under the tree at the wrong time the effects can be clearly harmful. You can make plans on the risk of subway times; you cannot do the same for coconuts.[2]

The types of risks have to be categorized and then portfolios have to be adjusted to the events which we may face. 

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[1] The differences between risk and uncertainty has been an ongoing discussion since the time of Keynes and Frank Knight. Risk is measurable and can be counted or form a clear distribution. Uncertainty may not be given an objective distribution and is more subjectively measured.

[2] This subway/coconut analogy was developed by Spyros Makridakis, Robin Hogarth, and Anil Gaba, three leading experts on decision sciences in their book, Dance with Chance: Making Luck Work for You. The book is a very accessible and practical read on how to deal with risk and uncertainty based on the current decision science research.