What on earth is Barry Ritholtz going on about…
December 10, 2012 20 Comments
…in this post?
When we don’t know what any future outcome will be, but we understand the probability distribution — think of dice or a multiple choice exam — we have risk, but we do NOT have uncertainty. We never know what the roll of the dice will be, but we do know its one of six choices.
1. Risk IS uncertainty. That is the definition of risk. Please let me know if there are any questions.
2. If you know the distribution, you know the distribution, but that doesn’t make it non-uncertain. The distribution is perfectly known in a die roll, or in craps, but nevertheless if you make a bet on those things, your money is at risk, because you are not certain what the outcome will be. That is how normal people would talk anyway.
3. Perhaps more to the point: in financial markets, Ritholtz’s alleged forte, one never ‘knows the distribution’. There are times when it may be convenient to act as if you know the distribution, or some approximate distribution – you hedge a derivative with hedge ratio X because you think the prices of the derivative and its underlying would move together in that ratio, not because you ‘know’ it. This means that, by Ritholtz’s construction, the markets have no ‘risk’ – just ‘uncertainty’.
None of this makes sense. So what is he really on about? Who is he really arguing against in his head, and what assertion(s) did they make, that annoyed him enough that he felt the impulse to try to define risk in such a weird and idiosyncratic way like this? In other words, what makes him think that trying to force there to be a distinction between ‘risk’ and ‘uncertainty’ was an important rhetorical tactic?
Speculations welcome. Actual author explaining himself, more than welcome.
UPDATE: I think I’ve gotten confused in comments trying to untangle the semantics (since I basically use the words interchangeably). Basically Ritholtz isn’t denying that a die-roll is risky, he’s saying we ‘don’t have uncertainty’ if we know the probability distribution – just risk. Two things. 1. While it’s true we ‘don’t have uncertainty’ about a die-roll’s probability distribution, that’s not the same thing as having no uncertainty about its outcome. The fact that we speak in terms of probabilities is precisely because we are uncertain of its outcome. Again I ask the question, would Ritholtz feel the need to hedge such an outcome? You don’t have to hedge certain events. (Actually, you can’t; no one would sell you such a ‘hedge’.) 2. ‘Knowing the probability distribution’ is not something that ever happens in the markets. Even on the die roll, how do you know the die is fair? You assume it? Hmm, people assumed house prices couldn’t go down. Since in reality, the world is always ‘uncertain’, risk and uncertainty are identical in practice, even by Ritholtz’s standards.