Uncertainty and Risk: The Lightness and Darkness of Compounding Consequences.


A recent article by David Kaufman (You don’t have to be Einstein to understand the pain of portfolio losses) raised an interesting thought for me: uncertainty is terrifying to us because of the exposure to compounding losses. As the article adroitly explains, compound losses can easily be disastrous.

The compound losses require asymmetrical gains to become even whole again:

Loss       Gain required to recoup

10%                      11%
20%                      25%
30%                      43%
40%                       67%

Why? Because you are trying to build from a much smaller base.

I would suggest that this asymmetrical exposure to compounding losses is one we encounter much more under circumstances of uncertainty than we do risk like ones. Why? Because we know enough about our risks to manage exposure to losses much more easily and effectively. Uncertainty, by definition is a state of being knowledge deficient or ignorant on potentially serious aspects of a future event. Secondly, risks are something often have had experience with. Uncertainty are future events with which we have had no or useful experience with. I draw these insights from my understanding of Nassim Taleb’s work (Black Swans, Anti-fragility, etc.)

I have lamented to others that we seem to want to lump uncertainty into the risk like category. Why? Lack of clarity on the effective difference? Psychological reasons?

Yet the fundamental strategy for dealing with uncertainty in our lives is simple: avoid being caught in a scenario of compounding losses if the event occurs. This is the “duck”, “step side”, be “immune” like strategies. When successful we remain whole after the event encounter.

There is a further goal we can pursue in dealing with uncertainty and its exposure to compounding effects. We could try and set ourselves up so if the event occurs,we only experience the compounding benefits. This is what Taleb means by “anti-fragility”.

This isn’t always easy to figure out, but I do argue: If we continue to confuse/muddle up uncertainty with risk, we are less likely to be successful because the core strategies for dealing with risk and uncertainty are different. Managing risks are often about managing likelihood (probabilities). With uncertainty, we do not understand likelihood in any useful way. Furthermore, unlike risk, we often do not fully appreciate the consequences of an event.

There are times when it is okay to be casual with our concepts and the words associated with them. I wonder if it is really in our best interests to be casual when the consequences of lack of clarity or specificity unduly exposes us to compounding losses.

 

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About 123stilllearning456

As a management consultant I am passionately interested in talent management and risk/uncertainty issues. In the area of talent management I propose that we seek strategies that look beyond the staffing/employee centric frames of reference. I have been frustrated at the "closing down on possibilities" by these more conventional staffing/employee centric approaches. I have been impressed where people have found systematic solutions to their talent management issues by going beyond the conventional approaches. In the area of risk and uncertainty, I am interested in making this topic relevant to more normal decision making situations. My conceptual foundation is to use the micro-economist's fixed/variable cost theme. I also think it is important to look at these issues for people through their emotional and psychological lens. As a premise I think risk and uncertainty only exist where there is a person who cares about possible events and its consequences. Hence, risk and uncertainty are social based concepts (no sentience, no risk and uncertainty). A major influence on my thinking in this area is Nassim Taleb of "Black Swan" fame. This BLOG provides me with an opportunity to express my thoughts on topics that interest me. As this is an online diary, content is more important to me than polish. I apologize if this distracts from readers' enjoyment and learning. Still I find this a useful way to live up to my namesake, learn more from others and hopefully provoke creative thoughts and ideas in others.
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