When it comes to trading, most individuals distinguish between “risk” and “uncertainty,” but often confuse “risk” with “uncertainty,” even though they are not synonymous.
It is important to remember at all times:
- Risk is not the same as uncertainty. Optimal decisions made in the face of known risks are not necessarily the best approach to deal with uncertainty.
- Simple heuristics are not foolish. In a world filled with uncertainty, simple heuristics are more helpful in making sound decisions compared to precise calculations.
- Complex problems do not always require complex solutions; it is better to seek simple methods first.
Differentiating Risk from Uncertainty for Informed Decision-Making
In “Risk Savvy: How to Make Good Decisions,” Gerd Gigerenzer focuses on the certainty illusion in risk perception. He uses the terms “known risk” or “risk” to represent calculable probabilities based on experience, and “uncertainty” to indicate risks where probabilities cannot be computed. This distinction leads to two sets of thinking tools:
Risk
When risks are known, making wise decisions requires logical thinking and statistical reasoning.
Uncertainty
In the face of unknown risks, making informed decisions necessitates intuition and wise heuristics.
While we distinguish between “risk” and “certainty,” we often mistakenly lump “risk” and “uncertainty” together. In reality, they are not synonymous. In a world of known risks, where everything, including probabilities, is certain, statistical and logical thinking is sufficient for making wise decisions. However, in a world of uncertainty, not everything is known, and we cannot make optimal choices through calculations alone. In such cases, we need to rely on wise heuristics and intuition to make informed decisions. In the business realm, statistical calculations alone are insufficient. Jack Welch, one of the world’s most successful corporate leaders, explains that his good decisions were made “through intuition.”
Improve Decision-Making
Most of the time, the probabilities of events are unknown, leading us to face numerous unknown risks or uncertainties. Compared to risk, uncertainty has a broader scope. In a world filled with uncertainty, we cannot select the ideal course of action through precise risk calculations. We must deal with the “unknown unknowns,” which inevitably lead to surprises. However, even when we cannot find clear answers through calculations, we still need to make decisions.
Typically, we dislike uncertainty and always hope for everything to be certain. However, the pursuit of certainty hinders our understanding of risk. Take breast X-rays, for example. 44% of survey respondents believed that the results of a breast X-ray examination are absolutely reliable. Yet, in reality, approximately 10% of breast cancer cases cannot be detected through X-ray scans. If the women undergoing the examination are younger, the likelihood of errors increases because they tend to have denser breast tissue.
In a rapidly changing world, the excessive pursuit of certainty can bring about risks. While we can almost certainly predict the return of Halley’s Comet in 2062, we cannot forecast natural disasters or stock market crashes. By analyzing thousands of predictions from political and economic experts, we find that their accuracy is not significantly higher than that of laypeople or dart-throwing chimpanzees. However, experts excel at finding reasons for their own mistakes. The problem, though, is that relying on inaccurate information can cause tremendous damage. Blindly trusting various tests and financial forecasts can jeopardize our physical and mental well-being, deplete our bank accounts, and even disrupt the entire economy.
The Three Faces of Probability
In the realm of probability, there exist three distinct faces: frequency, physical design, and credibility. These three facets constitute the essence of probability, each contributing unique characteristics to its understanding.
Frequency
As the first facet of probability, involves calculations. By dividing the number of rainy days or successful baseball hits by the total number of days or total hits, we arrive at the relative frequency, which represents probability.
Physical design
The second facet of probability, pertains to structure. For instance, a fair die is symmetrically designed, and without any calculations, we know that the probability of rolling a six is 1/6. Such well-designed probabilities are referred to as “propensity,” with games of chance relying on luck being typical examples. These risks are known.
Credibility
The third facet of probability, is dependent on factors like personal experience and individual impressions. Historically, credibility originated from the testimonies of eyewitnesses in courtrooms, but noteworthy are the legends of miracles in Judaism and Christianity.
Known risks can be calculated using frequency or physical design, whereas credibility is subjective and variable. With a substantial amount of data or a well-defined design, probability can be computed using frequency and physical design. In contrast, the probability range of credibility is broader, indicating its application to any problem. However, the danger lies in the easy assumption that calculating probability alone can solve all uncertainties, which could overshadow other vital tools like empirical rules.
Importance of Probability in modern technology
While the three facets of probability may not be significant when it comes to rolling dice, they become crucial in the context of modern technology. The probability of a major accident occurring at a nuclear power plant can be calculated based on previous incidents, the physical design of the plant, and the credibility of experts. These three methods can be used individually or in combination, but the results of the calculations may vary significantly. Calculating the number of accidents at a nuclear power plant is straightforward, but determining the propensity for accidents based on the plant’s design is challenging and subject to the expert’s stance. Hence, when we hear about the probability of a nuclear leak or any other risk, it is crucial to inquire about the methodology employed in calculating it.
Calculating risk is one thing; effective communication is another. Currently, two risk communication tools are prevalent:
2 Risk Communication Tools
Using frequency rather than the probability of a single event
The first tool helps us comprehend the likelihood of risk occurrence, such as precipitation probability. Stating “There is a 30% chance of rain tomorrow” represents the probability of a single event. On the other hand, saying “Within the days when this weather forecast is issued, it rains on 30% of those days” indicates that the reference is to days, not regions or time, making 30% the frequency.
Using absolute risk rather than relative risk
The second tool aids in understanding the variability of risks, as exemplified by the statement “Taking a new type of contraceptive pill increases the risk of blood clots in women by 100%.” This assertion might induce fear, but it is a relative risk, whereas the absolute risk only increases by 1/7000, which is the objective way of communicating risks.