KuU - Known, unknown and Unknowable risks

 

One way to stop the needless noise associated with measuring risk is to develop frameworks on how to look at the risk problem. All risk situations are not the same. A conceptual framework can help with analyzing problems and improving the precision of our thinking. Within risk management, a good framework was developed by Deibold, Doherty, and Herring in their under-appreciated book The Known, the Unknown, and the Unknowable in Financial Risk Management. The KuU framework focuses on three types of risk, the known which is measurable or countable, the unknown which is what many have called uncertainty, and the unknowable, what we are not able to imagine or a function of our ignorance. All are focused on our knowledge which is either based on a measurement problem and theory issue. In KuU framework, we an look at risk in three dimensions. 

K, the known, refers to the probability distribution for an asset. This is the classic definition of risk. The outcomes and the probabilities for a situation are known. Knowable situations are well understood. There is a model, and the model has broad agreement among users.

u, the unknown, refers to a situation where the probabilities cannot be affixed to a set of outcomes. This is what Frank Knight would call uncertainty. If there is an unknown situation, there may be competing models which only offers conjectures and not clarity on what is possible.

U, the unknowable, would be any situation where future events cannot be identified. The events and probabilities are not known. Under this situation, there is no underlying model that can address or be associated with a market situation. 

The KuU framework can be associated with risk, uncertainty, and ignorance. By looking at any situation through this lens, we can better frame possible solutions. Is the issue a measurement problem? Is it a situation where we cannot get a count or measure? Is this a situation of ignorance?

We can solve or reduce ignorance through deeper research of the risk problem. We can also work at better measurement of risk, so that we can place bounds on the downside. If we can control risk and improve measurement, we can focus on the real problem of uncertainty.