Uncertainty

You expect different returns on different investments. Uncertainty is the factor that causes this to happen.


Academics have their own precise definitions for the two terms 'risk' and 'uncertainty'. But we don't bother with any of that here, and nor should you. We'll just be careful to explain what we mean.

Certainty

If you lend £100 to the government at 3% you will have a return of 3%. Short of invasion or revolution, this return is certain. (Well, almost certain - only a British government default will defeat you).

Uncertainty

Suppose you lend £100 to the government for one year on the following terms: at the end of the year the Chancellor will toss a coin; if it comes down heads you will get your money back; if it comes down tails you will get 106% of your money back. Your average return is 3%. (The mathematician might say that your 'expected' return is 3%). But your actual return could be 0% or 6%. Your return is uncertain.

Which investment would you rather make?

The price of uncertainty

Obviously, you would prefer the certain 3%. (We have to pretend, for the serious business of investment, that gambling isn't fun).

But what if the Chancellor offers 108% if it comes down tails? You would now have an expected return 4% (average of 8 and zero) - an extra 1%. Would you do it? You would? Then how about 107% for tails? Now you expect only an extra 1/2%. Would you do that?

This cameo illustrates one of the key investment judgements. Does the extra return being promised offer sufficient compensation for the uncertainty of the promise? (In Advanced Investing this will be called the 'trade-off between risk and return').

Uncertainty = Risk

You won't see the word 'uncertainty' much in investment literature. What you'll see is the word 'risk'. But we prefer the former word here for two reasons. First, it is plain English and describes precisely what we are trying to describe. Second, the word 'risk' has been annexed  to describe and measure a very specific phenomenon - the extent to which the capital value of an investment oscillates. A financial adviser attempting to sell you a product may say that it 'reduces risk' when what he actually means is that its value is less volatile.

'Risk' is perhaps a word that is better reserved for things like loans to Dodgy Bank PLC (DBPLC). You would not lend money to DBPLC at 3% when you could get the same rate from the government. This seems different from the Chancellor's coin-tossing example somehow - more obviously 'risky'.

Well it is. But that's because in lending to DBPLC you are risking default - losing your capital and not just the interest on your capital. The stakes are higher. There's even a special name for it: 'counterparty risk'

But the principle is the same. You might judge there is a 1% chance of DBPLC defaulting within a year. So you need 4% (=3% + 1%) to break even. And you need more than that to compensate for the uncertainty. 5%? 6%? That's for you to decide. Either way this is just like the earlier example except that God (or maybe the managers of DBPLC) is tossing the coin.

 

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