The swine flu hasn't yet reached epidemic proportions. Nor has it come to ravage the UAE. But it does illustrate how a large-scale risk can just pop up out of nowhere, surprise everyone and have a big effect on our everyday lives. In some affected nations, people are walking around wearing surgical masks. All of the sudden, it's a so-called black swan.
Risks like this have obvious applications in investing and asset management. Yet I have a bit of a problem with this thing we call "risk". Fundamentally, I think it's an ill-defined concept. In fact, in my view, we may be incapable of even comprehending risk, simply because it's impossible to know what didn't happen but which could have happened. You know your chances on a six-sided die because there are only six possibilities. You don't know your chances of catching the swine flu because there is some large number of possible outcomes that could involve getting the disease or, for that matter, some other unexpected disease. Risk, therefore, is impossible to measure, even in retrospect.
Some people attempt to solve this problem by usefully distinguishing between risk and uncertainty. Risk is what you take when the odds are knowable (i.e. on a pair of dice). Uncertainty is what you confront when the odds are impossible to know. In investing, as in most of life, what we confront is uncertainty, not risk. And uncertainty is impossible to hedge.
Still, asset management folks go around every day talking about market risk as though it didn't involve uncertainty. They go on about how they've hedged this and that, how they've essentially managed to build up a risk-less portfolio with low volatility and high expected returns. They never prattle about an uncertainty-less portfolio. That would be absurd.
With the popularisation of a number of books on uncertainty, however, that's beginning to change. Investment pros, it seems, are starting to weave uncertainty into their discussions of risk, even if they still use the word "risk" to describe both. Take this quote, from Peter Preisler, the head of EMEA for T. Rowe Price. He was asked yesterday about what the swine flu tells us about risk in the modern financial world:
