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Risk and probability

We have just defined risk as a situation where the possible future outcomes are known and we can calculate the probabilities of these outcomes. This article will expand on this by giving some more examples.

A game of chance, the roll of a dice and gambling. Many people love it every now and then. The outcome is random. But, does this also mean that we cannot predict it? When, some random events are repeated over and over again patterns may start to emerge. If this is really the case perhaps, we can use this knowledge to say something meaningful about the future?

Even so, it might be impossible to predict the exact number of your next dice roll, but it is possible to calculate the probability of a certain outcome. To illustrate this, roll the dice in a virtual laboratory, keep the number of sides at 6, set both the number of dice and number of rolls at 99. You will see that while the patterns differ a lot the averages are fairly close to 3.5.

Keep in mind that in this example you know exactly what the outcomes may be. The dice can land on either one of six sides with equal probability. There is useful information in this knowledge. You can even calculate what the probability is of a specific number. You are able to calculate the probability of the dice landing at 3 - as ‘one in six’ or \(\frac{1}{6}\). This tool can be very powerful in real life. There are plenty of examples of this tool being used to make money. One profitable example is a casino. The casino offers various gambling games. And while the outcome of a game of roulette can be random for an individual, for the casino it is not. The casino plays so many games that, when using probability calculus, it makes money from all the games on average.

The use of probability theory for gambling was obvious. But as can be read in Peter L. Bernstein’s (1996) book ‘Against the Gods the Remarkable Story of Risk’, “As the years passed, mathematicians transformed probability theory from a gamblers’ toy into a powerful instrument for organising, interpreting, and applying information.”

Today probability theory and theories of risk are all around us. Especially in finance: risk management is a hugely popular and well developed field.

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This article is from the free online course:

Decision Making in a Complex and Uncertain World

University of Groningen

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