Uncertainty and risk

Risk is a core part of any business, and understanding the risk associated with uncertain future returns is at the core of Valuation. As a result, we spend a lot of time trying to reduce uncertainty, which has two problems: firstly we don’t understand uncertainty very well and secondly, profitable opportunities only exist where returns are genuinely uncertain.

There are two different kinds of uncertainty: Risk is where we know the potential outcomes in advance, and even maybe their probability. Think of rolling a dice: we know the range of potential outcome in advance, as we do their probability. Genuine uncertainty is different and occurs when complex systems interact over time: we know neither the possible outcomes of their probabilities in advance. The Geo-political economy is an example.

In his seminal work on the topic, Frank Knight wrote (in his 1921 book “Risk, Uncertainty and Profit) that real opportunities for profit exist on in the face of real uncertainty. In other words, if you want to make a profit you must not just deal with uncertainty, you actually have to seek it out.

The problem is that we act like everything is just a risk: In other words, when we use our opinions to estimate the probability of something, we treat this opinion as if it’s a real probability. We give mathematical weight to our subjective opinions, to our gut feel, and we treat anything uncertain as a risk where assume we understand the possible outcomes and their probabilities.

The alternative, where we act like everything is unknowable, is also fraught with problems. We live in a world of denial, of a self-image far better than it really is. When the occasionally some event is strong enough to break through our mental image and force us to face facts, the façade is revealed the world is terrifying…and seems too uncertain to act with conviction. So it’s back to our happy mental model where we treat everything as a risk.

So how to deal with uncertainty?

  1. Aggregate: we have insurance because it’s possible that our house will burn down. Insurance works because when you add up individual cases of uncertainty you get a probability. From an innovation perspective that means that you have to have many ideas to have a good chance of having one really great one. Volume reduces uncertainty, and this is what VC firms do when they invest in a lot of smaller deals (such as the Y Combinator or 500 Startups models).
  2. Seek out uncertainty to hit it big: innovation is good bet – while the average innovation makes only a small return, a small number of these innovations produce returns that are orders of magnitude different. This means that we need to treat innovation like a portfolio – we should innovate widely and cheaply, then throw our weight behind the ones that show real promise.

The better VCs use both of these models: they are risk averse (ask any entrepreneur whose pitch has been rejected), but the better ones actively seek out uncertainty.

So how do we measure uncertainty? Through waste: As William Janeway writes in his book Doing Capitalism in the Innovation Economy:

“Schumpeter’s process of creative destruction can only proceed by trial and error. We see that which is created through the lens of survivors’ bias and ignore the “hopeful monsters” that economic evolution has spawned and left behind in metaphorical emulation of Darwin’s process of natural selection. No doubt every one of them was launched on the basis of an exercise in forecasting future revenues, costs and an expected value to be compared with a rough estimate of the cost of capital. As Schumpeter well knew, the wastage is the measure of the inescapable uncertainty that attends the practice of doing capitalism: We need only visualize the situation of a man who would … consider the possibility of setting up a new plant for the production of cheap airplanes which would pay only if all people who drove motorcars could be induced to fly. The major elements in such an undertaking simply cannot be known … Neither error nor risk expresses adequately what we mean.”

So here is my challenge to big corporate innovation departments, to university IP commercialisation efforts, to the venture capital community, bankers and entrepreneurs: what are you doing to minimise risk but seek out uncertainty? How wasteful are you? As an economy are we wasteful enough, or are we a socialist state?