In The Art of Thinking Clearly the author, Rolf Dobelli, explains the following experiment:
Two boxes. Box A contains one hundred balls: fifty red and fifty black. Box B also holds one hundred balls, but you don’t know how many are red and how many are black. If you reach into one of the boxes without looking and draw out a red ball you win $100. Which box will you choose: A or B? The majority will opt for A.
Let’s play again, using exactly the same boxes. This time, you win $100 if you draw out a black ball. Which will you go for now? Most likely you’ll choose A again. But that’s illogical! In the first round, you assumed that B contained fewer red balls (and more black balls), so, rationally, you would have to opt for B this time around.
Don’t worry; you’re not alone in this error - quite the opposite. This result is known as the Ellsberg Paradox - named after Daniel Ellsberg, a former Harvard psychologist. The Ellsberg Paradox offers empirical proof that we favor known probabilities (box A) over unknown ones (box B).
I have written before about the difference between risk and uncertainty. Risk is calculable. That is, the odds are known. Uncertainty is not calculable. The odds are unknown. Time and time again in the investment management industry risk and uncertainty are confused for each other, which causes major problems.
Risk and uncertainty are both aspects of two different types of problems, complicated and complex, which also happen to be confused for each other. A complicated problem contains risk. It is like building a rocket ship. A blueprint to building a rocket ship can be replicated because building a rocket ship involves risk: it is calculable. On the other hand, a complex problem contains uncertainty. It is like raising a child. Raising one child the same as another often yields different results because raising a child involves uncertainty: it is not calculable. In the investment world, uncertainty (not calculable) is frequently mistaken for risk (calculable) with disastrous results.
The difference between risk and uncertainty also illustrates the difference between life insurance and credit default swaps. A credit default swap is an insurance policy against specific defaults, a particular company’s inability to pay. In the first case (life insurance), we are in the calculable domain of risk; in the second (credit default swap), we are dealing with uncertainty. This confusion contributed to the chaos of the financial crisis in 2008. If you hear phrases such as ‘the risk of hyperinflation is x percent’ or ‘the risk to our equity position is y,’ start worrying.
We do not like uncertainty; however, we live in an uncertain world. One would be well-advised to frequently pause to ask oneself if they are dealing with calculable risk or incalculable uncertainty before making any major decisions.