I recently received a comment from a reviewer on a study based on Modern Portfolio Theory (MPT) arguing that the concepts of "risk" and "uncertainty" should **not** be used interchangeably. As I understand (and without going into the discussion about how to include experts' options/expectations), both are measured as the standard deviation/volatility of an asset's time series in MPT, so I do not understand reviewer's comment. What I am missing?
PS: I edited the question because the **not** was missing (thanks, Peter Lerner, for noting that!)
In modern portfolio theory, risk and uncertainty are two different concepts that are used to describe the potential outcomes of investment.
Risk refers to the likelihood that an investment will not achieve its expected return. Risk is typically measured using statistical techniques, such as standard deviation or variance, which provide a quantitative assessment of the potential for an investment to lose value. There are different types of risk that can affect investments, including market risk, credit risk, and liquidity risk.
Uncertainty, on the other hand, refers to the lack of knowledge or predictability about the future outcomes of investment. Uncertainty can be caused by a variety of factors, including changes in market conditions, economic conditions, or political conditions. While risk can be measured and quantified, uncertainty is more difficult to quantify and may be subjective in nature.
In modern portfolio theory, risk and uncertainty are often considered in the context of portfolio diversification. Diversification is the process of spreading investments across a range of asset classes in order to reduce risk and uncertainty. By diversifying a portfolio, investors can reduce the impact of potential negative outcomes in any one asset class, which can help to increase the overall return of the portfolio.
Within the context of MPT "risk" and "uncertainty" both are measured with volatility. From your question it is not clear whether it was reviewer or you who stood on the position of interchangeability. Reread your second sentence. But, in spite of science, the reviewers can be pesky and demanding. Just do what you have to do to get the paper published. :)
In finance, as you said, typically we treat risk and uncertainty as the same because we measure (such as by standard deviation) both using the same metric. Outside of finance, risk is viewed as the chance of a loss (from known factors) whereas uncertainty is when you essentially have no clue what the outcome will be from unknown factors. In a CFA environment uncertainty would be called risk-risk.
Risk means exposure to loss or non-realization of the return, but the case of uncertainty means the possibility of exposure to loss or the possibility of achieving return or not
Dears,
Kindly, can we measure the financial risk management by using the market risk? If YES, is there any empirical study confirms it .....Thanks
Raymond A K Cox Peter Lerner Abbas Fadhil Resen Thales A.P. West
Uncertainty (Volatility) includes both gains and losses in a symmetric way, whereas financial risk is obviously associated with losses but not profits. You can calculate Value at Risk (VaR) as a measurement of risk. VaR represents how much a portfolio can lose within a given time period.
There is an abundance of studies that use market risk (beta in the capital asset pricing model of Sharpe, Lintner, and Mossin) as a measure of financial risk for an investment especially in a portfolio setting.
Refering to basic definitions from Knight (1921) and Keynes (1921), measurable uncertainty should be called risk.
Hence, non measurability means genuine uncertainty. In this case, there is no statistical or historical (i.e. objective) record upon which one can design predictions. This would apply to new (innovative) assets.
Of course, one can always use subjective probabilities and Bayesian inference, based on beliefs. This is quite another story...
The reviewer is correct that the concepts of "risk" and "uncertainty" are not interchangeable, despite both being often measured as standard deviation/volatility in MPT. While both risk and uncertainty relate to the degree of unpredictability associated with an investment's returns, they differ in important ways. Refer to the general meaning of the two terms.
In practice, it is possible to estimate risk using historical data, whereas uncertainty is often associated with future events and therefore cannot be quantified with historical information alone.
Therefore, it is important to use the terms "risk" and "uncertainty" appropriately and not interchangeably, as their differences have important implications for investment decisions and risk management strategies.
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