Managing risk is at the heart of investing, and an important component of risk management requires analysing the expected outcomes of economic events. In fact, much of financial theory depends on estimating the probability of outcomes. We devote considerable time to continually assessing potential risks, assigning probabilities to various potential outcomes and estimating how they will affect asset prices. But there is no crystal ball.
Frank Knight’s prescient 1921 book Risk, Uncertainty, and Profit is remarkably relevant to today’s market. Mr. Knight outlines distinct differences between “risk” and “uncertainty.” He posits that economic events should be placed on a spectrum between the two: events with outcomes that have known probabilities would be on the ‘risk’ side of the spectrum and those where probabilities are unknown are on the ‘uncertain’ side.