Turning uncertainty to risk is profitable, so invest in it!

Entrepreneurs live life doing business in a VUCA (volatility, uncertainty, complexity and ambiguity) environment. Volatility means that tendencies of the market can change drastically. Complexity means that decisions affect many variables which in turn affect each other so having a clear vision of how things will play out is hard. Uncertainty means that you face situations of risk which are hidden or unknown. Ambiguity means that you can read a situation, equally rationally, one way or the other. Risk on the other hand is barely present in an entrepreneurs’ life. Risk involves known probabilities, and you can actually measure the odds of something happening and act accordingly just like pros at a casino. If entrepreneurs’ lives were full of volatility, complexity and risk (eliminating uncertainty and ambiguity) there would be millions of entrepreneurs more because they actually could measure risk and make safe bets.

Maybe Donald Rumsfeld, in his declarations about the war in Iraq in 2002, captured the essence between risk and uncertainty better than me, when he stated that the dangers the US faced included “the known knowns, the known unknowns and the unknown unknowns. Risk is a known known, you know that a flip of a coin will land heads with a 50% chance. But uncertainty would mean that the coin is biased and you don’t know whether it is biased towards heads or tails. This exactly resembles the type of uncertainty entrepreneurs face most of the time and it is exactly what most people try to avoid, thus having an aversion towards this known unknown.

To prove the existence of the uncertainty aversion which affect most people, Daniel Ellsberg, a US military analyst with a PhD in Economics from Harvard published a paper in 1961. The so-called Ellsberg Paradox shows how people overwhelmingly will choose situations of risk avoiding situations of uncertainty. The experiment consists on that there are two urns with 100 balls each with two color possibilities: black and red. It is known that the first one contains 50 black balls and 50 red while in the second one the ratio between black and red is not known. It is only known that all of the possible ratios are equally likely. So each individual got to choose from which urn they would draw one ball and if the ball they chose is black they would earn $100. An overwhelmingly majority chose the first urn (with known probabilities) even though in both urns, the probability of drawing a black ball was the same 50% (crunch the numbers if you will). If people where 100% rational, computed the statistics and are indifferent emotionally to irrelevant factors (like the uncertain ratio in the second urn) the percentage of people choosing the first urn would be similar to the percentage choosing the second urn. Even after explaining people that the probability to draw a black ball in both urns are exactly the same, the Ellsberg Paradox held and a vast majority of people still selected the first urn. The first scenario involves risk only, the second urn has an uncertainty component in addition. The fact is that people have a strong aversion to uncertainty.

So how does this aversion impact us and the economy?

1. The uncertainty aversion will of course deter people from starting their own business at the cost of leaving their job as an employee. This will happen even if the employees´ expected payment is much lower than the expected gains from being an entrepreneur. It will even hold when such employees dislike their job. Gripping to such jobs as employees will be stronger if debts are higher, of longer term, and the number of family dependents increase. People will rather go with the devil they know.

2. In the same line, the uncertainty aversion will prevent people from engaging in innovation, be it as an entrepreneur, manager or as an employee. There is a high degree of uncertainty when a company will launch a completely new product for which there are no prior experiences in the market. How to know whether something will be accepted by the market if it is something completely new? The jobs of the inventor, product manager and owners of the company will be on the line, so why take all that uncertainty? We all know that the higher the risk the higher the return. But I would go further, the higher the uncertainty, the even higher the returns. A company in this situation will try to, spending millions of dollars, to produce studies which will transform uncertainty to risk in order to take the decision to launch or not the new product. Uncertainty suddenly cost millions of dollars.

3. Insurance companies, of all types, benefit from the uncertainty aversion. Furthermore, it is their reason to exist. Insurance companies gather and crunch the numbers to estimate your risk, of say, having a heart attack. They can do this segmenting their beneficiaries population as much as they can and mixing it with statistics. After estimating the cost they will add their margin. The possibility of a heart attack to you is uncertain, since you do not have the power or information necessary to estimate the probabilities, and so you can´t estimate the expected cost of a heart attack. If you could, then you could save just enough monthly for that future cost. Your uncertainty is a risk for the insurance company, and as such they can cost it, manage it and profit from it. That is the power of information and statistics. Of course their portfolio is big so thanks to the law of big numbers and other statistical laws, their estimates will be pretty close to the real number in general.

From this last point we can infer a lesson. Converting uncertainty to risk is actually profitable. Market researchers make a living out of it. They try to turn the uncertainty of how markets would accept a potential product to risk, so that the decision will come down to known probabilities. That is the reason of analytical tools and data analysts to exist, they use big data to try and turn uncertainty to risk and exploit it so that precision is acquired, budgets are met, money is not wasted in extra inventory, productive resources are not sub utilized, etc.

I guess what I am trying to say is that this is one of the strongest pieces of evidence about how information is money.

In order for an economy to be able to boost entrepreneurship, innovation and competitiveness it is of extreme importance to promote and adopt a culture of gathering, processing and analyzing information with the best knowledge and technology available. This way uncertainty turns into risk and it can be managed and exploited. This is one of the flanks of attack to reduce the influence of oligopolies (price influencing industries). These companies will not profit from priviliged information turning uncertainty to risk. They would only have high returns if they take higher risks only.

Just to make a little advertisement for retail-store companies anywhere in the world: if you want to maximize floor sales, optimize the sales-force, prices and margins let me know. Our company (pioneer in the world) is dedicated to it with great results (extremely high ROI) by means of turning uncertainty about demand (traffic to the stores) to cuantifiable risk, and by that managing supply and inputs to maximize sales.

#uncertaintyaversion #beha #ellsbergparadox #entrepreneur #decisionmaking #economics