Uncertainty vs. Risk
– Justin Haley
– Justin Haley
With Halloween still visible in the rear-view mirror, let’s play a game. Imagine you are a vampire, with long canine teeth and everything. It’s nearly sunrise, and you have pulled your blackout shades to enjoy a nice day’s sleep. You bunch up your comfortable down pillow, and a few minutes later, you are sound asleep, dreaming whatever imaginary vampires dream about. But suddenly, there’s a noise outside your house, and you wake with a start. The noise sounded very much like a threat. You feel an urgent need to know what is happening, and you reach up, hands shaking a little, to retract your blackout shades. If it is still daylight, you’ll fry to a crisp. If the sun has already set, you’ll be OK unless the noisemaker is dangerous.
Before we address our frightened vampire, the question of whether something is a risk or an uncertainty has come up a lot during the pandemic. To be clear, risk is when the potential outcomes of something are known, as is the probability of each of those outcomes. Banks deal with risk every day, particularly in their loan portfolios. A loan will either be a good loan, with the borrower paying the debt as agreed, or a bad loan, where the borrower fails to pay the loan off. We have access to lots of data on which to do statistical analysis, which helps us calculate the odds of a particular borrower ending up in one of those two situations.
However, when the pandemic hit, suddenly, almost everything we normally did was clouded with uncertainty. Uncertainty is when you cannot determine what the potential outcomes are and/or cannot calculate the odds of such outcomes. For example, which borrowers would struggle from the economic fallout of the pandemic? Which could be helped to stay on their feet with loan payment deferrals? How long would the pandemic last? These are just three of the many, many questions we wrestled with from March until now. The outcomes for some of our questions were known, but the odds were not. In some cases, neither the possible outcomes nor the odds were known. Without being able to quantify the risks, we were forced to use our best judgment to get through the uncertainty. As a result, we first determined that behaving conservatively was our best option, the choice that reduced the downside of a bad guess to some degree. Once we had a directional indicator for our decision-making, it was easier to figure out where to act to limit the bad outcomes. Not that doing it all was easy or the decisions painless, but at least we were no longer picking from an unlimited number of options.
So, back to our vampire. Should he retract the blackout shades? That is a risk. Either it is daylight, and he’s toast, or it is night, and he’s safe. There are only 24 hours in the day, so odds can be calculated. But the source of the noise outside is uncertainty. The answers seem to be, but aren’t quite, limitless. And he has no way of putting odds on the options because he is not sure of the options.
If I’m that vampire, I’m not taking the risk that it’s still night by retracting the shade. Instead, I would wait for more information. Even though the source of the noise could be anything, I understand that even these unknown odds are likely small odds, particularly if I factor in that a threat is likely to present additional data before I’m unable to deal with it. Instead of touching the blinds, I get back into my comfortable coffin and drift off again, dreaming those vampire dreams.