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Causal Capital ~ The Knowledge Capital Specialists

Uncertainty and the Oberserver

Our previous blog posting on The Importance of Risk Definitions [LINK] has sparked a lot of interest among the Causal Capital and G31000 reader communities.

Various well respected and articulate risk managers have put questions or commentary forward in respects to the schematic published in our earlier article. I want to list two comments in particular before exploring them further.

» "I'm submitting that terminology used within much of Enterprise Risk Management is incoherent because it results in infinite recursion and unresolvable self-references" | William Storage

» "There is insight introducing recognition of biases as it contributes to uncertainty" | Patrick McConnell

At a mathematically implied level or how risk is experienced in the real sense; Risk and its counterpart Uncertainty are concepts that are interlaced in ways that forbid the separation of the two terms at an interpretive level.

I am sure you have heard someone say in reference to the unfortunate; "well they didn't see that coming did they" and herein lies the consideration that if there was no uncertainty, those that may suffer need to bear risk. Additionally, there is a substantial difference between A Risk and An Issue, the latter being something you must endure and while it is not desirable, it isn't unexpected.

In his wonderful book "How to Measure Anything", the author Douglas Hubbard rationalises this dilemma in a comparative way by describing the world of uncertainty as sitting in one of two opposing states.

There is a frequentist interpretation of probability that places chance as not a state of an observer but simply an objective random feature of the system being observed. In this purest essence, uncertainty is nothing more than variables that change within a system or just systematic variance if you prefer. It can’t be risk because of the subjective detachment from the stakeholder’s interest.

When I observe the average weight of salmon in a river by sampling them, I do not change their weight, but I am altering my uncertainty about their weights. | Douglas Hubbard

If you have read this far down in our article here, you may be thinking this is all quite intellectually fastidious but rest assured such deliberations are anything but academic as we shall see shortly.

What we can appreciate from Hubbard's remark is that uncertainty belongs to the observer because of their subjective interest in the system, the randomness is present in the system either way. However, to the observer they are not impartial to randomness when they are modified from the effects that prevail. Even if the source of randomness is error while monitoring a stationary system or impatient biases from lack of signal, uncertainty may move to its maximum potential while the real threat lays dormant.

Opaque markets tend to be volatile, who would know?

Eight Idioms of Risk

The inability to accept the two domains of uncertainty that Hubbard describes, is pure arrogance. This is a form of bias that feeds uncertainty and has speculators going short when markets extend or socialist analysts and their followers believing they have won the republican race when quite the opposite is true.

For what it's worth, it wasn't a race after all but an outcome the 'average Liberal Democrat' will now have to accept. As for the markets, they had a positive response from the Trump victory, who would have thought? ... Dormant uncertainty (nothing happening) fed volatility in the early stages that fooled all that were watching and saved those that were blind to reality (not observing). Those holding long positions on the other side of uncertainty were rewarded for making their various speculative choices.

Eight Risk vs Uncertainty Realisations

My area of interest lies in risk management and the inseparable duopoly between Risk on one hand and Uncertainty on the other. This will lead to incoherence in my opinion unless the observer is able to move beyond a frequentist interpretation of probability.

The Risk Innocuous Lumpen-Proletariat

[1] Risk is surely a bad thing I must reduce it, can we have yield without risk?

[2] Is risk in randomness, chance or luck and is there any opportunity without risk?

... Most English dictionaries stop here

The Domain of Traders, Gamblers and Opportunists

[3] Can I benefit from opportunity without risk, can I benefit from risk?

[4] Perhaps risk is my ignorance of how things work, can I have absolute insight?

... The immoral stop here

A Risk-Balanced Manager

[5] The future is uncertain, the past is incomplete, are all objectives coupled with risk?

[6] When I use novel controls on new risks, my risk goes up. Can I do harm to the system?

... A conservative but strong risk manager stops here

The Supposed

[7] Am I outside the system? ... Should I question the system?

[8] There are n dimensions to risk

... Those that feed off uncertainty never stop until uncertainty ends

There are eight steps or evolutionary idioms that need careful consideration. I have turned these idioms into paradoxical questions that risk managers must be comfortable in answering when they are presented with risk management situations in commercial settings.

In our next posting on Uncertainty and the Observer, we will demonstrate a risk management model that shows how to encompass the observer's sentiment or bias in a risk measurement and evidence the types of impacts that can occur when it is excluded.

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