Uncertainty means that people are ignorant about some things, in particular, they lack information about the future. A wide range of future outcomes are possible (potentially infinite). You might step in a puddle of mud on the way to class. Or you might anger an intelligent extraterrestrial life form that retaliates by destroying all life on the planet. You just never know. That is uncertainty.
Uncertainty is translated into the related notion of risk by assigning probabilities to the possibilities. While it is possible that you could either step in a mud puddle or your could cause total destruction of the planet, both are not equally likely outcomes. Risk is the process of assigning probabilities to these alternatives (for example, 99.999999999% chance of mud puddle stepping versus 0.000000001% chance of total planet destruction).
Risk and uncertainty are important to financial markets. The exchange of financial instruments, such as stocks and bonds, are based on uncertainty of the future, tempered with attempts to quantify the risk of different possibilities.
Uncertainty versus RiskA concept related to uncertainty that is frequently (and erroneously) used synonymously is risk. They are, however, different concepts, and the differences are important.
Uncertainty is simply the observation that the future is unknown. You don't know what will happen tomorrow. Any number of events might occur. You could eat a ham and swiss cheese sandwich for lunch. Or a meteor could crash through your ceiling and destroy your computer. Or you could have a pop quiz in your anthropology class. Or you might receive an unsolicited telemarketing phone call for vinyl siding. Or the battery in your car might go dead. A lot could happen. Almost anything is possible. Not knowing what will happen is uncertainty.
Risk, in contrast, is assigning quantitative probabilities to the possibilities. For example, you might have a 50% probability of eating a ham and swiss cheese sandwich for lunch tomorrow. And the probability of a meteor crashing through your ceiling and destroying your computer is only 0.00000000001%. An anthropology pop quiz might have a 10% chance of happening. The chance of a call from a vinyl siding telemarketer might be 20%. And a dead car battery has a 2% probability.
Translating uncertainty into risk begs the question: How are these quantitative probabilities identified? How do you know that a ham-and-cheese lunch has a probability of 50%, but a computer-destroying meteor has a chance of only 0.00000000001%?
In some cases the probabilities are subjectively determined. That is, you guess. You have a hunch. It just "seems" like you have a 20% chance of receiving a telemarketing call for vinyl siding.
In other cases the probabilities are based on historical records. If, for example, you have eaten a ham and cheese sandwich for lunch 15 out of the last 30 days, then the chance of doing so tomorrow is 50%. If your anthropology instructor has given 2 pop quizzes over the last 20 days, then you can calculate the probability of a pop quiz tomorrow at 10%.
In still other cases, the historical data is augmented with information about other cause-and-effect connections. The chance of receiving a telemarketing call might be lower that historical data suggests if you recently added your name to a "do not call" list. The probability of an anthropology quiz might be higher if you know that your instructor likes to give quizzes at the end of the week and tomorrow is Friday.
Insurance companies, government policy makers, financial investors, and many others facing the uncertainty of future events, spend a great deal of time and effort working through historical data and cause-and-effect links to assign probabilities to the possibilities. Insurance companies assign the probability of having a car wreck. Policy makers assign the probability of having an economic contraction. Investors assign the probability of a stock price increasing.
InsuranceUncertainty of the future and the quantification of this uncertainty as risk is fundamental to the provision of insurance. Insurance is a service that transfers the risk of large losses from an individual to a larger group. The larger group is typically represented by an insurance provider. This transfer of risk is undertaken in exchange for a premium payment. That is, the individual agrees to incur a small guaranteed loss (the premium) but avoids incurring a less likely but much larger loss.
For example, a person pays an automobile insurance premium each month (guaranteed), but shifts the (slight) risk of a major expense associated with an accident to the insurance provider.
The insurance provider spreads this slight risk of a large expense for one person over a large group, the vast majority who pay the premium but do not incur the expense. Suppose, for example, that insurance is provided to 100 people and one member of this group is involved in an accident that incurs a cost of $20,000. The insurance provider spreads this $20,000 expense over the 100 people by charging each a premium of $200.
The key is that the insurance provider knows that 1 of the 100 customers will incur the $20,000 expense, it just doesn't know which specific person it will be.
Financial MarketsRisk and uncertainty are also key to financial markets. Financial markets exchange financial instruments or legal claims, such as stocks, bonds, and futures contracts. The most common financial market is the stock market that exchanges corporate stock, which are legal claims representing ownership of corporations.
Those who buy and sell legal claims do so with recognition that the future is uncertain. However, they also attempt to transform this uncertainty into quantifiable risk. For example, you might be willing to buy a few shares of OmniConglomerate, Inc. based on expectations that the company will be more profitable in the near future.
While the future profitability of OmniConglomerate, Inc. is uncertainty, you might be able to assign probabilities to alternative outcomes. Perhaps you know that over the past 20 years, the company has had positive profit three-fourths of the time and a loss only one-fourth of the time. The odds are three to one of a positive profit in the coming year.
You might then adjust this probability with other information. Perhaps because you heard that the company is on the verge of obtaining a lucrative government contract. Or perhaps you read that the economy will be prospering and with it the demand for company production will increase.
The accuracy of the information plays a big part in who "wins" and "loses" in the financial markets. If your information is better and the price does increase, then you win. If the seller has better information and the price decreases, then you lose.
UNCERTAINTY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2021. [Accessed: March 7, 2021].