Uncertainty versus Risk

One of the attractions of my job is that the topics we debate often get right to the heart of central philosophical problems. One such incident occurred today during a morning meeting discussion about Boeing. The analyst who covers the stock and has a neutral rating on it was attempting to justify his position to a bullish portfolio manager.

The background is that Boeing has recently has some negative newsflow regarding its new 787 model. This, and some concerns over how events in the credit markets will effect the company's ability to finance itself, has caused the stock to seriously underperform in the past couple of months. The portfolio manager was pushing the analyst hard on why he thinks there is further downside. The scale of the underpeformance, he argued, has been so large that the bad news must already be priced into the stock.

The debate became rather heated, climaxing with the analyst saying something along the lines of, "one hundred extra hours of modeling wont make it any less riskier because there is a much higher level of uncertainty now". Now this statement is interesting because it highlights the key difference between "risk" and "uncertainty". As analysts, we are constantly trying to measure and model "risk" so that we can come up with a "price target" for stocks based on the probability we assign to different scenarios. However, there is another type of risk called uncertainty, or "Knightian uncerainty" - named after Frank Knight who invented to concept, which is basically risk that cannot be modeled. As Knight defined it:

"Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.... 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 phenomena 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 unmeasurable one that it is not in effect an uncertainty at all."

My own view is that uncertainty is something that is vastly under-appreciated and misunderstood by market participants. The tendency toward making assumptions and building extensive models often leads people to false conclusions. What tends to happen is that uncertainty is just ignored, especially if it cannot be modeled. I noticed this most recently in the carbon trading space, in which the market is currently very bullish. This is not the right time to go into a detailed explanation of this debate (I'll leave that for another post) but suffice it to say that the market is currently only focusing on what can be modeled - the potential revenues from trading carbon allowances. Unsurprisingly it is not difficult to generate a lot of upside, especially if you make generous assumptions about the political-economy situation post Kyoto. But this approach completely misses the point that there is high degree of uncertainty around the stocks, not least the fact that their existence is entirely dependent on a market that has been created by politicians and can easily be taken away again. There are a number of ways this could happen - public opposition, fraud, lack of effectiveness, consistently bad newslfow, but this risk cannot really be modeled or quantified. Therefore it is ignored!

Anyway, back to my original point. I don't know very much about Boeing, but I'll certainly listen to the analyst again in the future as I was impressed by the way he defended his position.