Risks are everywhere. It's a wonder that anyone leaves their house each morning to venture into the world, or to venture into projects and investments. In this article we will look at the meaning of risk.
There are many definitions of risk depending on the context, or industry. Also, risk is frequently used as a catch-all word for when things don't go as planned, or hoped.
Risk vs. Uncertainty
When we engage in some activity such as conducting a project, making an investment, etc. there is some form of uncertainty in the outcome. Many times risk and uncertainty are used interchangeably. Economists often make a distinction between the two, however. Frank Knight distinguished a difference between risk and uncertainty. Risk has a known probability, while true uncertainty does not. In fact, with uncertainty, we may not even know the possible outcomes.
In systems engineering, Blanchard & Fabrycky also make distinctions between decision making under risk and decision making under uncertainty. They use probabilities for risk, and not for uncertainty.
Risk arises from uncertainty, and therefore risk is a subset of uncertainty. We can also think of risk as the part of uncertainty where probabilities are known. True or complete uncertainty is where we don't have any idea of the probabilities.
Certainty >>> Risk >>> Uncertainty
When dealing with risk, we are taking probability into account. Probability may be based on historical data, an understanding of the nature of the system (a coin has a 50% chance of heads, and 50% chance of tails), or estimates based on opinion.
Meanings of Risk
Sometimes risk is defined as the uncertainty associated with all outcomes. For example, investment risk is the volatility of returns, both good and bad.
Often risk is associated only with bad outcomes, where the uncertainty of outcomes to the downside is of importance in risk analysis.
No matter what we define as risk, it cannot exist without uncertainty.
Most of the time, a positive occurrence such as completing a task early, or better than expected investment return is not a concern, it's a good thing. So when talking about risk we are generally referring to something negative. This may not always be the case, though. What if we overestimated the resources required to finish a major task, and diverted those resources from other activities only to find out that the task was easier than originally thought? Resources that are not easily switched among tasks could have secondary costs (losses) that may be adverse to other projects.
Another case would be completing a project critical path task so early that it no longer lies on the critical path. This case could have resulted in a waste of resources since they probably should have been diverted to a different task.
Components of Risk
Using the definition of risk being a negative event, risk has two main components:
- A loss.
- The probability of occurrence.
A loss can represent many things. Some examples of loss are:
- Monetary loss
- Loss of life
- Reputation damage
- Schedule slippage
- Product performance
- Project technical performance
- Property damage
- Legal judgments
The product of loss and the probability comprise the risk level that is present. A major loss with a low probability could represent a catastrophic event. A minor loss with a high probability could represent a significant risk that adds up because of its frequent occurrence.
For more on project risk management and risk analysis, check out these links.
Knight, Frank H. Risk, Uncertainty, and Profit. 1921. Library of Economics and Liberty. Retrieved January 22, 2018 from: http://www.econlib.org/library/Knight/knRUP1.html
St. Louis Fed. The Stock Market: Risk vs. Uncertainty. Fall 2012. Inside the Vault. Retrieved January 22, 2018 from: https://www.stlouisfed.org/Publications/Inside-The-Vault/Fall-2002/The-Stock-Market-Risk-vs-Uncertainty
Blanchard, B., Fabrycky, W. Systems Engineering and Analysis. 2006. Prentice Hall.