My sister called me ugly, but we are identical twins (Or why we should not shoot the ugly sister)

By Taylor Murtha, QUT Master of Applied Finance student

Risk is the team of scientists in the corner doing the calculations to figure out how close they are to a mission failure. Uncertainty is Neil Armstrong putting his foot on the moon hoping it doesn’t collapse or explode and send him into the abyss. Like identical twin sisters they are similar in appearance but they are different in nature, risk is highly quantifiable whilst uncertainty is not. The human equivalent of risk is Warren Buffett, he makes an assumption about the possible outcomes and their likelihood and makes an investment decision based on that information. The human version of uncertainty is Richard Branson, who doesn’t know all the possible outcomes or the specific probabilities but he thinks it is a good idea so he invests. Obviously Richard Branson is far more interesting then Warren Buffett because he is wild and unpredictable which is the perfect metaphor for uncertainty.

So if we like Branson more than we do Buffett, why is uncertainty the ugly sister in the finance world? They can both make you a billionaire, they both have unknown outcomes, but only one can give you reassurance and that’s what helps you sleep at night. People want to know what is going to happen with their money with some certainty. If I asked you to invest $100 with an 80% chance I will return you more than $100 you are likely to consider it because there is a large possibility you will be better off. If I asked for the same amount of money and said I don’t know whether you will get it back again or not you are not likely to invest the money. Whilst in both cases the maximum you stand to lose is $100 you don’t know the likelihood in one scenario and that’s why it’s the ugly twin.

“You shouldn’t judge a book by its cover” and “it’s not the looks, it’s the personality that counts” are classic quotes that everyone pretends to accept but actually ignores. The best looking book is always picked up first in the book store, much like every supermodel in the nightclub, even though the plain book or wall flower probably has more to offer. Just imagine, you might choose that plain book and realise it conveys the meaning of life as written by god. What I mean to say is that a project that has uncertainty rather than quantifiable risk might actually be the better choice, simply because you stand to generate real profits. With risk however, comes an expected payoff and therefore you pay the fair price for that risk.

So risk offers no bargains, it offers expected returns for given levels of risk and you will pay and be paid accordingly. Uncertainty, by definition, is the unknown unknown and so there is no fair price that can be calculated. This is where profit truly lies. Risk and return is the sun and the moon, they move in relation to one another and therefore offer nothing extra … you don’t really make a profit. You make a return for taking a calculable risk for which you paid a price, no profit just returns on investments. Uncertainty means that you can make an abnormal return because you haven’t paid fair price, and this is profit.

Kodak, Nokia, Ericsson, Blackberry, Yahoo, and Blockbuster are all classic cases of companies that eventually became irrelevant when they started to take calculable risk. My personal favourite is Xerox, who specifically funded a research team to innovate and developed the modern day personal computer, peer-to-peer computing, laser printing, Ethernet and dozens more brilliant ideas that are all used by other companies today. Whilst the management was bold enough to embrace the uncertainty inherent in new technologies it left it up to other market participants to profit from it at the cost of taking their share price from $64 in 1994 to $7 in 2001. Another classic example is Kodak who invented the digital camera but failed to embrace the new business model the disruptive change opened up.

Risk is not valueless in the presence of uncertainty, if you can calculate your risk it offers a lot more stability and predictability which is great for public monopolistic companies and their share price. Whilst innovation is not exclusive to start-ups they are much more willing to embrace it as they have a lot less to lose then a large company. Nevertheless, in an increasingly competitive and digital world protecting your current business model no longer guarantees its future success.

Separating risk and uncertainty is not just splitting hairs, they are not identical twins but they are sisters, neither of which is ugly. Risk is the more responsible sister aware of the consequences of running with scissors. Uncertainty is the more adventurous sister who is running around trying to chop her sisters’ hair off. It is her that gives businesses a glimmer of hope of creating value in the long-run.

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