Understanding the Difference Between Uncertainty and Risk

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In the post-COVID-19 global economy, there is more risk and uncertainty than ever before. From concerns over industries collapsing to fears that stagflation will be the new norm, it is tough owning and operating a business right now – large or small. Governments and central banks are employing a series of fiscal and monetary relief and stimulus measures, but these cannot be permanent solutions to the problems facing the marketplace; as economists say, there isn't such a thing as a free lunch. 

Yet even before the pandemic, these words – "risk" and "uncertainty" – were regularly used by experts and economists, often interchangeably. What do they actually mean? Are they the same thing? And why, as a business owner, should you necessarily care?

To provide answers to these questions – and, indeed, to highlight the need to understand the difference between uncertainty and risk – we've compiled a comprehensive breakdown of the two terms. After all, the ability to differentiate and distinguish between them can make a significant difference in your analysis and projections, making you more future-proof and better prepared.

What is Risk?

Risk is the probability of future events occurring, usually with negative connotations for your corporate objectives (although sometimes they can be positive). Businesses of all sizes will incorporate a wide variety of risk management strategies to deal with the factors that influence risk, such as competition, government regulations or consumer preferences. Professionals will either contain the negatives or expand upon the positives.

Here are some examples of business risk:

Compliance Risk 

If your organisation has failed to act in accordance with industry regulations or government laws, then you are exposing yourself to compliance risk. Whatever the case may be, minimising this risk is critical, as your firm is likely to face legal penalties or financial forfeiture as a result of your illicit activities and violations. 

Reputational Risk 

Reputation risk refers to the loss of capital – both financial and social – that a reputational disaster can incur. The best way to measure the losses stemming from reputational damage is through diminishing revenue, increased regulatory costs, or the decline of shareholder value. A business' reputation could take a hit from, say, a scandal-laden CEO, corporate layoffs, or bad consumer reviews. 

Strategic Risk 

Every organisation can incur significant losses thanks to an unsuccessful business plan that failed to resonate in the marketplace. Perhaps your company bet on a particular strategy, but it could not spur a modicum of success. 

Operational Risk 

Operational risk is more of an umbrella term to define the various unsystematic risks that are unique to your business or specific industry. Ultimately, operational risk consists of the various challenges in conducting day-to-day business activities and depend on the human element (decisions made by employers or employees).

What is Uncertainty? 

Uncertainty, however, refers to a situation where future events and outcomes are unknown and incalculable. You cannot find something out for certain, and the factors relevant to your company are uncontrollable and indefinite.

Here are some examples of business uncertainty:

State Uncertainty 

This occurs when your business cannot determine what will take place. This can be in a broad sense; for instance, an opposition political party might propose a slate of radical regulatory changes that are at odds with current legislation, and which significantly affect your operations. Until the results of the election are known, you cannot act either way. Such uncertainty can also be tangible on a smaller scale, such as if you own an events company and have scheduled large outdoor events without being able to know the weather. 

Effect Uncertainty 

This is when you have an idea of what might happen, but there is still an element of uncertainty that could impact your enterprise in the present or the future. Take the events example; you might have scheduled your outdoor event, and you know for certain that it is going to snow or rain. However, what you don't know is if it will still prevent consumers from attending. 

Response Uncertainty 

You have crunched the numbers, considered all the angles, and factored for a multitude of potential circumstances. With these elements at your disposal, you have crafted the perfect response. Or so you think. Response uncertainty relates to being unable to be sure of how your customers will react to any actions you might have taken. 

It should be noted that risk and uncertainty also possess unique definitions in various industries. The terms have specific connotations in, for example, project management or software development. That said, it is still critical to differentiate between the two terms, especially in a wider commercial context.

The Importance of Distinguishing Between Uncertainty and Risk 

While many choose to use the terms loosely, it incorrectly conflates every concept behind risk and uncertainty. Both words are indeed meant to highlight the engagement of any unknown potential outcome, but the difference is distinct, as economist Frank Knight argued in his 1921 book, Risk, Uncertainty, and Profit:

"It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We shall accordingly restrict the term 'uncertainty' to cases of the non-quantitive type. It is this 'true' uncertainty, and not risk, as has been argued, which forms the basis of a valid theory of profit and accounts for the divergence between actual and theoretical competition."

However, having accepted that there is a difference, the key question remains: why should you care? Let's quickly break down some of the common reasons. 

Firstly, identifying risks does not give you a competitive advantage because the chances are high that your rivals have already considered those same risks and examined the objective probabilities. 

Secondly, you cannot determine uncertainty, but you can venture a look at all the possibilities. Once you've opened Pandora's Box and written down every potential scenario, you can produce uncertain actions that might be more innovative, original and revenue-generating. 

Thirdly, the risk might not be as calculable as you would initially believe. Whether it's the result of cognitive biases or simply overestimating your analytical abilities, you might have a hard time putting together a risk-based model. On the other hand, the unknown is far less competitive; a lot of entrepreneurs are willing to take on risk, but they are not prepared to grapple with the unknown. 

Uncertainty demands its own category in the business decision-making process, and it could be far more profitable to home in on it than risk. 

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Analysts will contend that, as economic concepts, risk and uncertainty are here to stay; the financial crisis emanating from the public health pandemic has permanently weighed on both the public and private sectors. Besides, let's not forget: the US and China are still engaged in a trade dispute; the UK is still leaving the European Union; and North America is still instituting the United States Mexico Canada Agreement (USMCA).

Therefore, it is going to be difficult to navigate domestic and international markets for some time. Nobody knows for sure what is going to happen, which amplifies the innumerable risks and uncertainties plaguing businesses and economies everywhere. The only thing entrepreneurs and business owners can do is prepare for the worst with this overarching difference in mind: to mitigate risks and try to solve uncertainty.

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