Apr 15, 2012

the myth of risk reduction

garry kasparov, considering the slowdown in technological development*, writes that

People have a sense that we should receive benefits from our investment, but need to reduce the uncertainty. Risk should be less, but the income should be the same. This creates a gap, because in a free society, in a market economy, there is a direct relationship between risk and return. If you want to avoid risk, but receive ten percent of of your annual income from your investment, you open the way for the so-called financial engineering. In fact this is all fake, not real income, because it is not based on real changes in the economy, because you do not create new and tangible assets. In the 1960s young boys dreamed of becoming aerospace engineers, now they want to be financial engineers, working in investment companies, which are the most attractive spheres for talent. This naturally affects the quality of the total scientific potential, because financial engineering creates nothing.
he's right, of course, though it would have been nice to distinguish between risk and uncertainty as frank knight (1921) did:
Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.
the return on any investment (or, more generally, the outcome of any action) comprises three conceptually distinct components: a known part, a knowable unknown part, and an unknowable unknown part. the knowable unknown is risk, and risk can be "reduced" or "managed" by spending effort, time, and money in advance: gathering information and preparing defensive assets of a known nature and quantity.

the unknowable unknown is uncertainty and is not reducible by advance action. the only way to "manage" uncertainty is to be ready to respond to conditions as they change unpredictably: this is costly in a different way since it requires creating a potentially enormous reservoir of excess capacity with which to respond. maintaining this excess capacity is expensive and may not pay off in the short or even the medium term.

responding to risk and responding to uncertainty require different approaches and different processes. all innovation requires both types of response. innovation in rapidly and unpredictably changing environments requires more preparation for uncertainty than risk. surprise! this will be my dissertation.

* found, since i read chessbase only infrequently, through tyler cowen's marginal revolution.

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