4.1 Risk and uncertainty
The terms ‘risk’ and ‘uncertainty’ tend be used interchangeably in normal language; however, they have different technical meanings, set out by Knight (2012). Take a situation where there are several possible future outcomes. We cannot say which will occur, but if we can assign probabilities to the likelihood of each possible outcome occurring, we have a situation of risk. (These probabilities can be determined by reference to the relative frequency of outcomes that happened in the past. Alternatively they may be estimated from market research or using the expertise and experience of the staff involved in a project.) If we cannot assign probabilities to the likelihood of each possible outcome occurring, we have a situation of uncertainty.
Note that, technically, risk and uncertainty do not necessarily have negative connotations. They simply mean that future outcomes are not known with certainty. Where they are present, it means that cash flows could be better or worse than their estimated values. However in everyday use, risk and uncertainty are typically used to mean outcomes which are worse than a level previously predicted, so be aware of this difference.
You may notice that despite the definitions above, there is still a grey area between risk and uncertainty. While we may always be able to estimate probabilities of certain outcomes occurring, the degree to which these probabilities are accurately known is also subject to uncertainty. For example, if I am rolling a die or tossing a coin, I know exactly the probabilities that the possible outcomes have. However, a situation where you know the probabilities for certain is unlikely in business situations.
A manager trying to forecast demand for a new product may be able to estimate the probability of achieving sales of £500,000, £1,000,000 and £1,500,000 as 20%, 50% and 30%, respectively, based on past sales for similar products. However the probabilities themselves are not known with certainty. The amount of uncertainty will vary depending on the situation, so there will be varying amounts of uncertainty about the risks faced! In practice, you would have to use your judgement to decide whether probabilities can be estimated accurately enough for risk analysis to be worthwhile, or whether the project should be treated as having uncertain outcomes without probabilities attached to them.