PERSPECTIVES. Defining Risk. Glyn A. Holton

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2 Knight distinguished between probabilities obtained in two manners: A priori probabilities are derived from inherent symmetries, as in the throw of a die. Statistical probabilities are obtained through analysis of homogenous data. He recognized that, in the absence of symmetries or homogenous data, people may still somehow quantify their uncertainty. Returning to his example of balls in an urn, he considered a situation in which we do not know the proportion of red to black balls but we are allowed to look inside the urn and form our own estimate of that proportion. According to Knight, opinions such as these, made in the absence of symmetry or homogeneity, are the basis for most business decisions: Business decisions... deal with situations which are far too unique, generally speaking, for any sort of statistical tabulation to have any value for guidance. (p. 231) Knight was loath to attach the label probabilities to opinions formed in the absence of symmetry or homogenous data. He suggested that a priori and statistical probabilities reflect measurable uncertainty and opinions represent unmeasurable uncertainty. He acknowledged that other authors mark this distinction with the terms objective probability and subjective probability, but he preferred his own terminology: To preserve the distinction... between the measurable uncertainty and an unmeasurable one we may use the term risk to designate the former and the term uncertainty for the latter. (p. 233) This statement is Knight s famous definition of risk. Risk relates to objective probabilities. Uncertainty relates to subjective probabilities. Knight acknowledged that his use of both the terms risk and uncertainty did not conform to common usage. In this article, I use these terms more in accordance with common usage, which I will clarify shortly. Critique of Knight s Definition A criticism of Knight s definition is the obvious one that it really is not a definition of risk. According to common usage, risk entails both uncertainty and exposure possible consequences. Knight s distinction addresses only the uncertainty. His definition is based on a particular objectivist interpretation of probability. To Knight, probability is intrinsic to a proposition and depends only on necessary ignorance. Comparing this conception of probability with Keynes contemporaneous conception is informative. According to Keynes, probabilities apply not to propositions but to pairs of propositions: One proposition is not known to be true or false. The other is the evidence for the first. A probability, then, is a relationship between two propositions. In Knight s original example of balls in an urn, Keynes would say that the probability for the first man really is fifty-fifty. This is the probability that logically relates the proposition a red ball will be drawn to the proposition representing the limited evidence available to that man. Keynes interpretation of probability is objectivist because he stipulates that probability relationships are rationally determinate. According to him, if two individuals consider the same evidence for a proposition, they must assign the same probability based on that evidence. Given any two propositions, a probability relationship between them is a product of logic. Like Knight, Keynes accepted that in some situations of uncertainty, objective probabilities cannot be assigned. Accordingly, Keynes interpretation of probability is amenable to Knight s distinction between risk and uncertainty. But the distinction for Keynes is more complicated. For Knight, propositions are categorized as either risks or uncertainties. For Keynes, pairs of propositions must be so categorized. If we embrace a subjectivist interpretation of probability, Knight s definition of risk becomes empty. In the absence of objective probabilities (however defined), there can be no risks under his definition. Intellectually, objectivist interpretations of probability are difficult to defend. Knight s conception of probabilities depends on the notion of necessary ignorance, but how do we distinguish necessary from factual ignorance in any given situation? Ramsey criticized Keynes view that probabilities are rationally determinate relationships between pairs of propositions. Commenting on these logical relationships, Ramsey noted: I do not perceive them, and if I am to be persuaded that they exist it must be by argument; moreover I shrewdly suspect that others do not perceive them either, because they are able to come to so very little agreement as to which of them relates any two given propositions. All we appear to know about them are certain general propositions, the laws of addition and multiplication; it is as if everyone knew the laws of geometry but no one could tell whether any given object were round or square; and I find it hard to imagine how so large a general body of knowledge can be combined with so slender a stock of particular facts. (pp ) , CFA Institute

3 Defining Risk Even Knight s a priori probabilities those based on some symmetry of a problem are suspect. One issue is the fact that problems can exhibit multiple symmetries. Savage offered the example of an urn that contains two balls: Both may be white; both may be black; or one may be white and the other black. Based on one symmetry, we might ascribe each possibility a 1/3 probability. An alternative would be to perceive four equally likely possibilities: (1) the first ball is black and the second ball is black, (2) the first ball is black and the second ball is white, and so on. From this perspective, there is a 1/4 probability of both balls being black, a 1/4 probability of both being white, and a 1/2 probability of one being black and the other being white. A final criticism of Knight s definition is that it appears to have only parochial relevance. For economists, Knight s distinction parallels divisions between types of economic activity. His notion of risk (measurable uncertainty) conforms to many contingencies that are the province of insurance. His notion of uncertainty (unmeasurable uncertainty) conforms to many contingencies that confront entrepreneurs or speculators. Accordingly, economists have found it useful to embrace some form of distinction between measurable and unmeasurable uncertainty. The validity or usefulness of such a distinction continues to be a topic of debate among economists. In other contexts, Knight s distinction is less relevant. In finance, it has played essentially no role. Harry Markowitz Finance emerged as a subject independent of economics during the 20th century. Some authors, including Louis Bachelier (1900) and Alfred Cowles (1933, 1944), published papers we would today consider finance, but they are recognized as such more in retrospect than they were in their day. The Journal of Finance was launched with little fanfare in The event that marks the emergence of finance as an independent subject seems to be Harry Markowitz s defense of his doctoral thesis in the University of Chicago economics department. Markowitz s thesis comprised his theory of portfolio selection. At its defense, his doctorate was in jeopardy. Sitting on the examination committee was Milton Friedman, who protested that the thesis was not about economics. Neither was it about math or business administration. Friedman was not sure how to categorize it, but he was averse to granting a doctorate in economics based on a thesis that was not about economics. Fortunately, Friedman s protests did not sway other members of the committee, and Markowitz received his degree. 1 His 1952 paper, which he had previously published in the Journal of Finance, spawned the field of portfolio theory. Portfolio theory is generally perceived as a body of models that describe how investors may balance risk and reward in constructing investment portfolios. It is interesting that Markowitz offered no definition of risk in 1952; he simply proposed the following rule:... that the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing. (p. 77) That is all he said. If variance of return is a proxy for risk, Markowitz did not say so. He simply stated that it is an undesirable thing. Only toward the end of the paper did he note: The concepts yield and risk appear frequently in financial writings. Usually if the term yield were replaced by expected yield or expected return, and risk by variance of return, little change of apparent meaning would result. (p. 89) This statement suggests that variance of return might be a proxy for risk, but Markowitz is careful to distance himself from that association. As it is worded, his comment suggests that other authors treat risk as akin to variance of return. Markowitz s finesse may stem from his perspective on probability: He wrote as a subjectivist. One of Markowitz s professors at the University of Chicago was Leonard Savage, a leading advocate of the subjectivist interpretation of probability. Savage s influence on Markowitz s 1952 paper is evident. Footnote 7 of that paper describes probabilities as in part subjective. Commenting on how to construct means and covariances for use in optimization, Markowitz suggested that procedures should combine statistical techniques and the judgment of practical men. Seven years later, in his 1959 book, Markowitz referred repeatedly to subjective probabilities which he and Savage called personal probabilities. Markowitz cited the works of both Ramsey and Savage, and he devoted a chapter to subjective probability. In an autobiography Markowitz penned when he received the 1990 Nobel Prize in economics, Markowitz identified two thinkers who profoundly influenced him while he was a teenager. One was Charles Darwin. The other was David Hume. Uncertainty Based on common usage, uncertainty is a state of not knowing whether a proposition is true or false. November/December

5 Defining Risk Operational Definitions Anatol Rapoport (1953) observed: It is not necessary to look into books on philosophy to find words without referents. Any commencement speech, sermon, newspaper editorial, or radio commercial follows the same philosophic tradition of reinforcing the delusion that anything which is talked about is real: success, charity, public opinion, and fourway indigestion relief. Indeed, nothing is easier than to define these noises so as to make it appear that they mean something. What is success? Success is the attainment of one s ideals. What is charity? Charity is the practice of Christian attitudes. What is public opinion? Public opinion is the prime mover of public policy in a democracy. What is four-way indigestion relief? Fourway indigestion relief is a gentle action which alkalizes the system, purifies the blood, activates the bile, and helps Nature to re-establish equilibrium. (pp ) Rapoport was commenting in the context of operationalism, a philosophy introduced by Percy Bridgman in his 1927 landmark work The Logic of Modern Physics. Bridgman was troubled by a passage from Isaac Newton s (1686) Principia. Newton stated: I do not define Time, Space, Place or Motion, as being well known to all. Only I must observe that the vulgar conceive those quantities under no other notions but from the relation they bear to sensible objects. And thence arise certain prejudices, for the removing of which, it will be convenient to distinguish them into Absolute and Relative, True and Apparent, Mathematical and Common. (1) Absolute, True, and Mathematical Time, of itself, and from its own nature flows equably without regard to anything external, and by another name is called Duration. (1848 translation, p. 13) Newton speaks to us through the ages. He was interested in time, and we are interested in risk, but his observations are applicable for our needs. We want to understand the risks we face, but we can hope to understand only those aspects that are sensible. Newton proposed a distinction between that which is true and that which is apparent. To him, there is true time and apparent time. With a single paper, Albert Einstein (1905) dispensed with Newton s notion of true time. He proposed that if two observers are moving relative to each other, their experiences of time will differ; all motion is relative; so all time is relative. There is no true time. Humans may speak of such notions as truth, virtue, time, distance, risk, or market value as if they were real notions endowed with an objective existence. Reacting to the revelations of Einstein s relativity, Bridgman proposed his alternative view, called operationalism. 4 He surmised that if all knowledge of the world stems from our experiences, then definitions can be meaningful only if they refer to experiences. He suggested that we formally define a concept by specifying a set of operations through which that concept is experienced: In general, we mean by any concept nothing more than a set of operations: The concept is synonymous with the corresponding set of operations. (p. 5) Suppose an analyst at an international wholesaler compiles closing coffee prices for the day by obtaining the spot price of the company s last transaction in each grade of coffee prior to 4:30 p.m. New York time. The reporting system records the time of each trade to within a minute, and on one particular day, the system reports two transactions in Colombian UGQ at 4:26 p.m. The two trades were at slightly different prices, and there were no subsequent trades. Shrugging, the analyst averages the two prices and records the result as the closing price for Colombian UGQ. A traditional interpretation is that the analyst has recorded her best estimate of the closing price. According to operationalism, there was no true closing price for the analyst to estimate. The traditional view holds that we measure a quantity q to obtain a quantity m that satisfies the equation m = q + e, where e is the error in our measurement. According to operationalism, the quantities q and e do not exist. All that exists is the measurement m, which is defined by the operations by which it was obtained. In the example, the notion of closing price is defined by the set of operations with which the analyst obtained her value. What do we mean by the correlation between three-month LIBOR and six-month LIBOR? What do we mean by the market value of spot copper? What do we mean by the leptokurtosis of spot cocoa prices? We mean only the set of operations by which we calculate such quantities. Bridgman s operationalism has much in common with the (largely concurrent) logical positivism of the Vienna Circle. 5 Bridgman wrote for scientists, so operationalism found acceptance among November/December

7 Defining Risk Notes 1. This event is described in Bernstein (1992), p Shackle indicated that the notion of most enjoyment is equivalent to that of least anguish. 3. Because animals have limited knowledge, they are capable of uncertainty. Those that can anticipate pain or pleasure are capable of exposure. 4. Bridgman avoided attaching a name to his ideas. Competing names, operationalism and operationism, were adopted by subsequent authors. 5. The Vienna Circle was a group of philosophers and scientists who met periodically in Vienna from 1922 to Their logical positivism became one of the most influential philosophical movements of the 20th century. Carl Hempel wrote a critical article titled A Logical Appraisal of Operationism (1965) that identified differences between operationalism and logical positivism. References Arrow, Kenneth J Le Rôle des Valeurs Boursières pour la Repartition la Meilleure des Risques. Econometrie, Colloques Internationaux du Centre National de la Recherche Scientifique, vol. 11: Translated ( ) as The Role of Securities in the Optimal Allocation of Risk-Bearing. Review of Economic Studies, vol. 31, no. 2 (April): Bachelier, Louis Théorie de la Speculation. Annales Scientifiques de l École Normale Supérieure, série 3, tome 17: Translated in Paul H. Cootner The Random Character of Stock Market Prices. Cambridge, MA: MIT Press. Bernoulli, Daniel Specimen Theoriae Novae de Mensara Sortis. Commentarii Academiae Scientiarum Imperialis Petropolitanae, vol. 5: Translated (1954) as Exposition of a New Theory on the Measurement of Risk. Econometrica, vol. 22, no. 1 (January): Bernstein, Peter L Capital Ideas: The Improbable Origins of Modern Wall Street. New York: Free Press. Bridgman, Percy The Logic of Modern Physics. New York: Macmillan. Cowles, Alfred Can Stock Market Forecasters Forecast? Econometrica, vol. 1, no. 3 (July): Stock Market Forecasting. Econometrica, vol. 12, nos. 3 4 (July October): Debreu, Gerard Representation of a Preference Ordering by a Numerical Function. In Decision Processes. Edited by R.M. Thrall, C.H. Coombs, and R.L. Davis. New York: John Wiley & Sons. de Finetti, Bruno La Prévision: Ses Lois Logiques, Ses Sources Subjectives. Annales de l Institut Henri Poincaré, vol. 7: Translated (1964) in Studies in Subjective Probability. Edited by Henry E. Kyburg, Jr., and Howard E. Smokler. New York: John Wiley & Sons Teoria delle Probabilità. Turin: Giulio Einaudi. Translated (1974, 1975) as Theory of Probability. London: John Wiley & Sons. Einstein, Albert Zur Elektrodynamik bewegter Körper. Annalen der Physik, vol. 17: Reprinted in The Principle of Relativity New York: Dover. Hempel, Carl G A Logical Appraisal of Operationism. Aspects of Scientific Explanation and Other Essays. New York: Free Press. Hume, David Enquiry Concerning Human Understanding. Keynes, John Maynard A Treatise on Probability. London: Macmillan. Knight, Frank H Risk, Uncertainty, and Profit. New York: Hart, Schaffner, and Marx. Kolmogorov, Andrey N Grundbegriffe der Wahrscheinlichkeitsrechnung. Berlin: Springer-Verlag. Translated (1960) as Foundations of the Theory of Probability. 2nd English ed. New York: Chelsea Publishing. Markowitz, Harry M Portfolio Selection. Journal of Finance, vol. 7, no. 1 (March): Portfolio Selection: Efficient Diversification of Investments. New York: John Wiley & Sons. Newton, Isaac Philosophiae Naturalis Principia Mathematica. Translated (1848) as Newton s Principia. New York: D. Adee. Ramsey, Frank P Truth and Probability. The Foundations of Mathematics and Other Logical Essays. New York: Harcourt Brace. Rapoport, Anatol Operational Philosophy. New York: Harper. Savage, Leonard J The Foundations of Statistics. New York: John Wiley & Sons. Shackle, George L.S Expectation in Economics. Cambridge, U.K.: Cambridge University Press. von Mises, Richard Wahrscheinlichkeit, Statistik und Wahrheit. 3rd German ed. Translated (1957) as Probability, Statistics and Truth. 2nd revised English ed. New York: Macmillan. von Neumann, John, and Oskar Morgenstern Theory of Games and Economic Behavior. Princeton, NJ: Princeton University Press. November/December

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