The Nature and Cost of Risk and Uncertainty

Posted in: Business Law

Why did people listen to the prophets and follow their predictions? Why do we seek information about tomorrow’s weather? Why do we attempt to find out the price of tomorrow’s stock? Perhaps the answer is that we are likely to benefit from the information. We could act or abstain from acting to protect our interests from possible harm or ensure or maximize possible profit. Information provides some certainty, regardless of whether it helps predict possible good or bad results. Knowing is likely to reduce choosing adverse future results.

We can view risk as a “possibility of loss or injury.” We view “pure” risk as the “only possibility of loss” (e.g., fire or theft). Somewhat differently, we view “speculative” risks as involving “the possibility of gain or loss,” such as in the case of investments. All these situations involve a lack of certainty about possible outcomes.

The financial area poses risks of losses. For example, in its annual report, Citigroup listed risks that could adversely affect its profits, including: (1) global and local economic conditions; (2) credit, market, and liquidity risk; (3) competition; (4) country risk; (5) “operational risk,” i.e., “the risk of fraud by employees and outsiders”; (6) U.S. fiscal policies; (7) harm to reputation and losses by possible legal violations; and (8) certain regulatory liabilities.

Risk differs from uncertainty.Scholars sometimes distinguish between risk (in which there are known probability estimates) and uncertainty (in which probabilities are unknown or disputed), although in practice, it is difficult to distinguish between these cases.” While risk can be measured more objectively than uncertainty, uncertainty may depend on the action or abstention of actors (person or organization) and is more subjective, depending on the risk-tolerance of others and their business, on regulators, and leadership.

Not everyone tolerates risk to the same extent. We define a risk-averse person as a person who “‘prefers certainty’ and ‘would be prepared to pay more than the expected value of the risk to avoid it.’” Other people are risk-neutral. “Parties are risk-neutral if they only care about the “expected value” of a future occurrence . . . .” Risk-seeking persons may bet on a positive outcome. Thus, risk-seekers, such as the buyers of a lottery ticket, are driven by the desire for the potential gain, “even though the expected value of that gain is less than the purchase price because of its small probability.”

However, generally, people resist change and uncertainty. Thus, an article in the Harvard Business Review on change in the business context suggests more generally, “People will often prefer to remain mired in misery than to head toward an unknown. As the saying goes, ‘Better the devil you know than the devil you don’t know.’”

Yet protections from risks of uncertainty have developed. When parties enter into an agreement, and one party promises the other to perform certain services, the decision of whether to act or avoid acting remains with the party that made the promise. This party determines the final promised action or inaction. The greater the range of this party’s freedom to change or avoid performing its promises, the higher the other party’s anxiety is likely to be. In such a case the dependent party may withhold some of its promised payment as a protection against possible violation. In other situations, a third party may back this possibility with a fixed obligation, and thereby reduces the risk.

Uncertainty raises varying degrees of anxiety in different people. Risks can result in loss of control, in unpleasant surprises, in self-doubt about one’s own competence, in a heavier burden of work, and in personal resentments, whether imagined or real. These reactions can accompany a positive result, which might bring benefits by avoiding losses. Most importantly, anxiety may be based on the fact that we do not know what the result will be. If a party, on which we rely, can use its power unpredictably, uncertainty rises, even though this party could use its power for our benefit, because we are uncertain whether this party would continue to use its power this way in the future.

Cultural reactions to risk have an impact. Members of different cultures react differently to risk. Some appear to be more risk-averse than members of another culture, Furthermore, the membership of two cultures may react differently. Members of one culture might tend to consider contextual concerns: family, reputation and career, and members of another culture might focus on specific metrics and logical rationales. These differences could reflect “cultural mediums such as the community environment, values and social interactions.” For example, members of the least risk-averse culture play games of chance such as Mah-jong and consider luck a “blessing,” and members of the most risk-averse culture believe that “one becomes worthy of good fortune through selfless sacrifice and self-control.”

A society, whose members cannot rely on each other, except by building specific assurance of future behavior, pays the cost of such assurances or the costs of uncertainty in the members’ relationships with each other. Uncertainty may lead not only to the adoption of protective measures but also to reciprocity. “If I do not know whether tomorrow you will change your mind and renege on obligations or other activities, why should I stick to my promises or behavior and let you dangle on the uncertainty tree?” Thus, some kinds of uncertainty can poison society beyond the particular relationships.

How should the issue of obligatory certainty be approached? Like many issues, leaders must set an example of reliable behavior and statements. If change is required because of changing circumstances, let the leaders clarify the reasons for the change and its limits, even if this change limits the leaders’ power. This is how we can learn clear commitments and create a fair, less anxious, society.

Yet, this conclusion is not the end of the story. Humans change from the day they were born, from childhood to adulthood, to retirement. Society and State change continuously as well. Humans are used to change and develop personal and group habits to cope with it. The key to anxiety-related change lies not in change, but in the lack of knowledge about where the change leads, and what to expect. When a parent changes the rules from day to day, or all of a sudden, children might develop a habit of protection from such surprises. But when the usual adaptive habits to change are not practiced, and when, in fact, rules are considered less constant, people are not protected from surprise, anxiety and frustration. That is, unless they were reared in this type of a rule environment and engage in protections from unexpected change.

Posted in: Business Law

Tags: investment, risk

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