Thursday, February 11, 2010

What is Risk?

If one accepts that probability theory is objectively valid and reliable, then drawing a distinction between what is knowable (probabilistically) and unknowable in matters of chance becomes instructive for informed decision-making in general. Prof Frank H Knight (1921) was speaking objectively when he proposed his infamous distinction between "risk" and "uncertainty." According to Knight (p. 233):
To preserve the distinction... between the measureable uncertainty and an unmeasurable one we may use the term "risk" to designate the former and the term "uncertainty' for the latter.
Knight's proposition contrasts with the earlier subjective views of David Hume (1748) who argued that chance is non-existent, therefore implying that the distinction between knowable and unknowable risks is a tautology. According to Hume (p. 469):
Though there be no such thing as Chance in the world; our ignorance of the real cause of any event has the same influence on the understanding, and begets a like species of belief or opinion.
The debate between the objectivist and subjectivist conceptions of risk continues to this day. However, the philosophical debate is more intense than ever given the reliance that modern finance makes of the objectivist approach to risk management and control (if that is even possible). I will not seek to resolve the two here. However, it behooves those intent on entering the field of finance to prepare themselves for this discussion. The future of financial economics may depend on your conclusions.


Hume, D (1748/1952), An Enquiry Concerning Human Understanding, in R M Hutchins & M Adler (Eds), Great Books of the Western World (Vol 35, pp. 451-509). Chicago, IL: Encyclopedia Britannica.

Knight, F (1921/2002), Risk, Uncertainty, and Profit, Washington, DC: Beard.

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