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The Stock Market: Risk vs. Uncertainty

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The Stock Market: Risk vs. Uncertainty
Life is risky. The future is uncertain. We’ve all heard these statements, but how well do we understand the
concepts behind them? More specifically, what do risk and uncertainty imply for stock market investments? Is
there any difference in these two terms?
Risk and uncertainty both relate to the same underlying concept—randomness. Risk is randomness in which
events have measurable probabilities, wrote economist Frank Knight in 1921 in Meaning of Risk and
Uncertainty.1 Probabilities may be attained either by deduction (using theoretical models) or induction (using
the observed frequency of events). For example, we can easily deduce the probabilities of the possible
outcomes of a game of dice. Similarly, economists can deduce probability distributions for stock market
returns based on theoretical models of investor behavior.
On the other hand, induction allows us to calculate probabilities from past observations where theoretical
models are unavailable, possibly because of a lack of knowledge about the underlying relation between cause
and effect. For instance, we can induce the probability of suffering a head injury when riding a bicycle by
observing how frequently it has happened in the past. In a like manner, economists estimate probability
distributions for stock market returns from the history of past returns.
Whereas risk is quantifiable randomness, uncertainty isn’t. It applies to situations in which the world is not
well-charted. First, our world view might be insufficient from the start. Second, the way the world operates
might change so that past observations offer little guidance for the future. Once bicyclists were encouraged to
wear helmets, the relation between riding the bicycle—the cause—and the probability of suffering a head
injury—the effect—changed. You might simply think that the introduction of helmets would have reduced the
number of head injuries. Rather, the opposite happened. The number of head injuries actually increased,
possibly because helmet wearing bikers started riding in a more risky manner due to a false perception of
safety.2
Typically, in situations of choice, risk and uncertainty both apply. Many situations of choice are
unprecedented, and uncertainty about the underlying relation between cause and effect is often present.
Given that risk is quantifiable, it is not surprising that academic literature on stock market randomness deals
exclusively with stock market risk. On the other hand, ignorance of uncertainty may be hazardous to the
investor’s financial health.
Stock market uncertainty relates to imperfect information about how the world behaves. First, how well do we
understand the process that generated historical stock market returns? Second, even if we had perfect
information about past processes, can we assume that the same relation between cause and effect will apply
in the future?

The Highs and Lows of the Market
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The Stock Market: Risk vs. Uncertainty

Warren Buffett, the world’s second-richest man, distinguishes between periods of comparatively high and low
stock market valuation. In the early 1920s, stock market valuation was comparatively low, as measured by the
inflation-adjusted present value of future dividends. The attractive valuation of stocks relative to bonds
became a widely held belief after Edgar Lawrence Smith published a book in 1924 on stock market valuation,
Common Stocks as Long Term Investments. Smith argued that stocks not only offer dividends, but also
capital appreciation through retained earnings. The book, which was reviewed by John Maynard Keynes in
1925, gave cause to an unprecedented stock market appreciation. The inflation-adjusted annual average
growth rate of a buy-and-hold investment in large-company stocks established at the end of 1925 amounted
to a staggering 32.13 percent at the end of 1928.
On the other hand, over the next four years, this portfolio depreciated at an average annual rate of 17.28
percent, inflation-adjusted. Taken together, over the entire seven-year period, the inflation-adjusted average
annual growth rate of this portfolio came to a meager 1.11 percent. Buy-and-hold portfolios in allegedly
unattractive long-term corporate and government bonds, on the other hand, grew at inflation-adjusted
average annual rates of 10.18 and 9.83 percent, respectively. This proves Buffett’s point: “What the few
bought for the right reason in 1925, the many bought for the wrong reason in 1929.” One conclusion from this
episode is that learning about the stock market may feed back into the market and, by changing the behavior
of the market, render our “learning” useless or—if we don’t recognize the feedback effect—hazardous.

Is Tomorrow Another Day?
Risk and uncertainty are two concepts that stem from randomness. Neither is fully understood. Although risk
is quantifiable, uncertainty is not. Rather, uncertainty arises from imperfect knowledge about the way the
world behaves. Most importantly, uncertainty relates to the questions of how to deal with the unprecedented,
and whether the world will behave tomorrow in the way as it behaved in the past.
This article was adapted from “The Stock Market: Beyond Risk Lies Uncertainty,” which was written by Frank
A. Schmid and appeared in the July 2002 issue of The Regional Economist, a St. Louis Fed publication.
Endnotes
1. This is the title of what is perhaps the best-known chapter in Knight’s book “Risk, Uncertainty, and
Profit.” [back to text]
2. For an article on this topic, see Julian E. Barnes, “A Bicycling Mystery: Head Injuries Piling Up.” The
New York Times, July 29, 2001, p. 1, col. 3. [back to text]

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Q&A

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Q&A
What is the FOMC?
The Federal Open Market Committee, or (FOMC), is the Fed's chief body for monetary policy-making. Its
members include the seven members of the Board of Governors and the 12 Reserve bank presidents. Alan
Greenspan, the chairman of the FOMC, is also the chairman of the Board of Governors.
Where does the FOMC meet?
The Board of Governors is located in Washington, D.C. The meeting takes place in its 56-foot-long
boardroom.
What happens at an FOMC meeting?
A senior official of the Federal Reserve Bank of New York discusses developments in the financial and foreign
exchange markets, as well as activities of the New York Fed's domestic and foreign trading desks. Staff from
the Board of Governors then present their economic financial forecasts. In addition, the Board's governors
and all 12 Reserve Bank presidents offer their views on the economic outlook. The FOMC discusses the
monetary policy options that would best promote economic growth with stable prices, and then it is time to
vote. The voting membership includes the seven governors, the president of the Federal Reserve Bank of
New York and four of the other Reserve bank presidents, who serve one-year terms on a rotating basis.
What does the FOMC vote on?
They vote on a directive that is issued to the New York Fed's domestic trading desk. The directive informs the
desk of the Committee's objective for "open market operations"—whether to ease, tighten or maintain the
current policy.
What are open market operations?
The FOMC establishes a target for the federal funds rate, the rate banks charge each other for overnight
loans. Open market purchases of government securities increase the amount of reserve funds that banks
have available to lend, which puts downward pressure on the federal funds rate. Sales of government
securities do just the opposite—they shrink the reserve funds available to lend and put upward pressure on
the federal funds rate. The amount of bank lending, of course, affects spending in the economy, which affects
demand for goods and services and, thus, prices. By targeting the federal funds rate, the FOMC seeks to
provide the monetary stimulus required to foster a healthy economy.
How is the public informed of FOMC decisions?
At the conclusion of each FOMC meeting, the federal funds rate target is announced to the public in a news
release. These news releases are also posted on the Board of Governors' web site at
http://www.federalreserve.gov/boarddocs/press/monetary/2002/.
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Economic Snapshot

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Economic Snapshot
3rd Quarter 2002
Q4-01 Q1-02 Q2-02 Q3-02
Growth Rate—Real Gross Domestic Product

2.7%

5.0%

1.3%

4.0%*

Inflation Rate—Consumer Price Index

-0.3%

1.4%

3.4%

1.9%

Civilian Unemployment Rate

5.6%

5.6%

5.9%

5.7%

*Preliminary

Graph from November 2002 issue of National Economic Trends.

Which agency is responsible for reporting GDP?
Gross Domestic Product, the output of goods and services produced by labor and property located in the
United States, is reported by the Bureau of Economic Analysis, U.S. Department of Commerce. For more
information, see www.bea.gov.

Why does a quarterly GDP growth rate number change?
Advance, preliminary and final GDP growth rates are released during the first, second and third months of the
following quarter. Changes result from incorporation of more complete information.

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