Monday, December 24, 2007

Uncertainty and Risk differentiated – Is a Tactical Surprise Preferable to a Strategic Surprise?

Risk management is a relatively new and evolving field. Risk management usually refers to the process of identifying, measuring, controlling, and minimizing uncertainties which may directly or indirectly affect a desired outcome of a system. A great challenge indeed.

Any process or procedure we can think of holds many uncertainties. Risk management tries to identify these uncertainties, assign probabilities and possible harm to each and every one and acts to minimize those risks.

One of the most counter intuitive questions in risk management basics is: What is the difference between risk and uncertainty? There are actually many differences; some are of the utmost importance to every organization and every manager.

When every possible option and outcome is known a decision is said to be taken under certainty. Many academic models assume certainty due to their basic function of explaining and prediction. These are also the standards most models are judged by. The recent retreat from certainty in academic modes has been due to explanatory gaps.

What is uncertainty then? Uncertainty is a situation in which possible outcomes of an action or decision are known but their probabilities are unknown or can not be assigned to each and every outcome. At this point intuitions should be baffled. What is risk then?

Risk is a situation in which possible outcomes of an action or decision are known and their probabilities are also known. What’s the difference? Risks can be identified, measured, insured against and minimized.

For example, insurance companies have very detailed statistics of accidents, thefts, earthquakes and even loss of limbs of famous and gifted football players. These are all risks. Uncertainties are also everywhere but can not be measured and as a result insured against. For example, who’ll be the next president of the US? That is quite a significant uncertainty.

However, the greatest significance of this differentiation between risk and uncertainty is their role in management. When all possible outcomes have probabilities assigned to them the biggest possible surprise for a manager is a tactical surprise.

For example, a fire might consume a warehouse but it can be rebuilt by insurance money or prevented by installing a sophisticated auto extinguisher.

When outcomes can not be assigned probabilities there is a chance of a strategic surprise. This is very dangerous for an organization as it might impact it in unforeseen ways. A certain legislation might pass which severely limits the organization’s ability to compete, a new technology may appear which will render the organization obsolete and much more.

Dealing with uncertainties is a manager’s duty which requires constant strategic thinking and evaluation. In order to better deal with uncertainties risk management practices should be put to use in strategic thinking as well and not just n operations and finance procedures where they are more common.


Jacob said...

Great post, I'm really learning from this blog. I have one question here: What are "unknown unknowns" called and how are they handled?

Dorian Wales said...

Hello Jacob,

Thank you for your feedback. Its the best motivation possible. As for 'unkown unkowns' - These are infinite. In my post on speculative and pure risks I mention the infinite amount of pure risks in every process (Think of the chances a piano might drop from the sky on your car for example...). In risk management we examine processes and try to identify the speculative risks and the major pure risks and usually multiply their effect by the probability of their occurence (most risk management models do). We adress the risks according to the outcome of the model. I'll write an article on this issue in the upcoming future.