RISK & UNCERTAINTY
In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the distinction between risk and uncertainty.
Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term "risk," as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an immeasurable one that it is not in effect an uncertainty at all. We accordingly restrict the term "uncertainty" to cases of the non-quantitative type.
Thus, Knightian uncertainty is immeasurable, not possible to calculate, while in the Knightian sense risk is measurable.
Another distinction between risk and uncertainty is proposed by Douglas Hubbard:
(i) Uncertainty: The lack of complete certainty, that is, the existence of more than one possibility. The "true" outcome/state/result/value is not known.
Measurement of uncertainty: A set of probabilities assigned to a set of possibilities.
Example: "There is a 60% chance this market will double in five years"
(ii) Risk: A state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome.
Measurement of risk: A set of possibilities each with quantified probabilities and quantified losses. Example: "There is a 40% chance the proposed oil well will be dry with a loss of $12 million in exploratory drilling costs".
In this sense, one may have uncertainty without risk but not risk without uncertainty. We can be uncertain about the winner of a contest, but unless we have some personal stake in it, we have no risk. If we bet money on the outcome of the contest, then we have a risk. In both cases there is more than one outcome. The measure of uncertainty refers only to the probabilities assigned to outcomes, while the measure of risk requires both probabilities for outcomes and losses quantified for outcomes.
The terms risk attitude, appetite, and tolerance are often used similarly to describe an organization's or individual's attitude towards risk-taking. One's attitude may be described as risk- averse, risk-neutral, or risk-seeking. Risk tolerance in the context of investing is defined by Investopedia “as the degree of variability in investment returns that an investor is willing to withstand. Risk tolerance is an important component in investing. You should have a realistic understanding of your ability and willingness to stomach large swings in the value of your investments; if you take on too much risk, you might panic and sell at the wrong time”. Therefore, the subject of Risk Tolerance deals with understanding one’s ability to accept or reject deviations from the expected results.
Risk appetite is the risk taking capacity and looks at how much risk one is willing to take. There can still be deviations that are within a risk appetite. For example, recent research finds that insured individuals are significantly likely to divest from risky asset holdings in response to a decline in health, controlling for variables such as income, age, and out-of-pocket medical expenses.
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