Risk and uncertainty are often used as synonyms; however, it is important to distinguish the difference between the two. For reasons I will hopefully make clear, a current lack of distinguishment regarding risk and uncertainty is a serious problem in the financial industry in my opinion.
Risk is calculable. It is a known unknown. It is a casino. A roll of the dice. A computer can calculate risk.
Uncertainty is not calculable. It is an unknown unknown. It is life. A black swan event. A computer can’t calculate uncertainty.
Nassim Taleb tells a story about the turkey illusion:
One day a turkey is approached by a man. The turkey is nervous, but the man feeds him. Each day the man returns, and each day the man feeds the turkey. The risk that the man will not feed the turkey decreases each day and is calculable. It is called the rule of succession and was created by Pierre-Simon Laplace- in the turkey illusion it equals (n+1)/(n+2) where n is the number of days the man has fed the turkey. If you plug in a few numbers, you can see that each day the man feeds the turkey the chance he will continue to do so increases (and, conversely, the risk he will not feed the turkey decreases). Everything is great for the turkey until the day before Thanksgiving when the man does something drastically different.
The turkey illusion illustrates the difference between risk, calculable by the formula (n+1)/(n+2), and uncertainty, that the man will one day do something unrelated to the feed-or-not-feed options to the turkey. A computer can calculate risk. A computer can’t calculate uncertainty.
The differences between calculating a problem using a computer versus a more qualitative approach is best explained by an example: In the book Risk Savvy the author, Gerd Gigerenzer, discusses how an outfielder catches a fly ball. Essentially, he or she subconsciously uses a rule of thumb. The individual runs towards the spot that keeps the angle of their view on the ball constant. A computer can’t calculate this trajectory as it is occurring. However, if you need to calculate the square root of a twenty digit number, a computer is your go-to choice. Point being, calculations are useful (and better) for some problems but not others.
There are many ways to make money investing; however, there is no “right” way in my view. It all depends on the individual, and some strategies are more responsible than others. In my opinion, quantitative investing can be a successful strategy. Despite this, as demonstrated by the fall of Long Term Capital Management in the late 1990s, models are great for calculating risk but not uncertainty. It is like the Ancient Egyptians who would build flood control systems to protect their villages based on the worst flood that occurred during the last 100 years. That is fine until something new happens in the next 100 years that is worse than before. There is an inherent flaw in creating control systems, such as financial models, based on the worst event in the past. This is because, as I have written before, black swan events are by definition unpredictable. They represent uncertainty and occur in the world we live in. To ignore uncertainty and only focus on risk, or even worse, think you are calculating both uncertainty and risk due to either a lack of understanding or mixing up the two, would be a drastic error.