Risk vs. Uncertainty

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Managerial Economics

Melissa Creggar

Unit 9

March 16, 2013

Risk is present when future events occur with measurable probability. Uncertainty is present when the likelihood of future events is indefinite or incalculable. Risk can be quantified either on the basis of prior knowledge or empirical observation. Investors can make arrangements to protect themselves against undesired risks, in effect converting risk into certainty. In other words, risk can be measured, avoided, managed, mitigated and/or transferred to another party. By contrast, uncertainty is not measurable, thus cannot be quantified or mitigated through other techniques. Uncertainty occurs in circumstances that cannot be analyzed or observed because they are not known, are unique or are too infrequent. Indeed, uncertainty is what is left over after we think we’ve thought of everything. (Hart, 2011) In this article it states that unfortunately uncertainty cannot be eliminated altogether so it would be very wise for investors and portfolio managers to figure out a way to channel and manage it. It also states long-term results that would normally turn out positive for the investor are not normally achieved without risk taking. Before the market crash, investors thought that having a diversified portfolio would keep them from losing a bundle; however, recent years have proven that just having a diversified portfolio isn’t enough. Although uncertainty can be viewed as the source of economic profit, there are still some steps that we are investors can take to protect our investments and manage our risk: * We can avoid it altogether by either disposing of an asset or not buying it at all. * We can retain it by knowingly accepting the exposure with the expectation that we will earn a commensurate return. * We can reduce it through thoughtful diversification strategies. * We can transfer it with portfolio hedging techniques. (Hart, 2011) Thus it is clear then that though both ‘risk...
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