What is risk?

Risk is a word that is very commonly used in business and throughout our daily lives. However, it is also a term that is fundamentally misunderstood. This can affect the way that people approach making decisions, and lead to decisions being made that are less than optimal.

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Fundamentally, a risk is something that can be measured. Because this measurement usually considers probabilities, risk can often be measured quite precisely. For this reason, the insurance industry is extremely fond of the idea of risk. Calculations for our insurance premiums are based, in first instance, on the probability of the event we are insuring against happening, but they also take into account our demographic profiles.

Because risk can be measured, it is only really appropriate to think in terms of risk when the data exists to allow such measurement to happen. Even then, calculations of risk are less than precise, reliable and accurate because, for example, we may not fit the demographic profile that our insurance companies use to assess us. This means that decisions made using calculations of risk are not necessarily as accurate as we think they are.

Even more fundamentally, corporate, political and other decision-makers often use the language and tools of risk to assess decisions for which appropriate data does not exist. Examples include the miscalculation of financial risk that led to the sub-prime mortgage crisis that triggered the 2008 global financial crisis (Shiller 2016) and political risk – the chance of disruptive political developments taking place that could affect investment decisions.

When aspects of the future cannot be measured using quantitative tools, we are dealing with uncertainty rather than risk (Knight 1921). This is a key distinction because uncertainty cannot be measured, meaning that it is inaccurate – and indeed unhelpful – to use the tools and language of probability. Instead, we need to find other ways to assess and respond to uncertainty. These are often more qualitative, and involve making judgements based on prior knowledge. We will look at decision-making under uncertainty in more detail later in the module.

Understanding the mathematics behind risk measurement and management is beyond the scope of this short course. However, what is important is to be aware that very often people talk about being able to measure the factors behind a decision they need to make, when in fact they cannot do this. Recognising uncertainty and being able to respond accordingly will help you to assess risk (and uncertainty) better, and hopefully enable you to make better decisions.

Your task

Can you think of any decisions you have made in the past that may not have been based on measurable facts? How did you feel about this? Were you happy with your decisions in hindsight?

References

Knight, F. H. (1921) Risk, Uncertainty and Profit. Boston: Hart, Schaffner and Marx

Shiller, R. (2016) Irrational Exhuberance 3rd edn. Princeton: Princeton University Press

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This article is from the free online course:

Decision-making and Risk: An Introduction

Coventry University