The Difference Between Risk and Uncertainty prevents everyone from businesses to investors from achieving their goals.
There are usually discrepancies or deviations between the expected and obtained results of businesses and investors. And this deviation creates risk. These risks play a role in the decision-making of businesses or investors. The result is the need to identify risks and measure risks.
Introduction
Rohan is a ninth grader. She expects a GPA of 5 in her SSC exams. Mr. Rashed is a farmer. He expects a good yield from the land this year. Sumona is a BBA final year student of Dhaka University. She hopes to get a good job after completing her BBA degree. Here Rohan’s GPA, Rashed Sahib’s good yield from his land, and Sumana’s good job are all uncertain.
Because everything is connected to the future. Rohan may or may not get a GPA of 5, Rashed Sahib’s land may or may not have a good yield this year and Sumona may or may not get a good job; May not get Thus various uncertainties exist constantly in the personal life of people. There are various uncertainties in business as well as in personal life.
For example, there is a lot of uncertainty about whether the company’s products will sell as expected in the future, whether it will be able to make the expected profit, and whether it will be able to buy raw materials at the expected price. Similarly, whether an investor will get the expected dividend by buying shares of a company, and whether a company will get the expected cash flow from investing in a long-term project, faces these uncertainties.
Because of these uncertainties, the actual outcome of various business decisions is more or less than expected. The risk that the actual results will differ from the expected results is called business financing. For example, the company expects to make a 20% net profit next year, but the actual profit is 15%. Here, this 5% deviation is a source of risk.
Below are a few more examples of risk analysis:
Suppose a company expects to sell products worth Rs 50 lakh, Rs 65 lakh, and Rs 75 lakh respectively in the next three years. But at the end of three years, it was seen that in the mentioned years, the company’s products were sold at Rs 45 lakh, Rs 60 lakh, and Rs 61 lakh respectively. An investor buys shares of a company expecting a dividend of Rs 15 per share per year. But at the end of the year, the company declared a dividend of only 10 rupees per share.
Every decision made by investors and businesses has a gap between expected returns and risk arising from the possibility of this gap. Note that even if the actual income is higher than the expected income of an investor, there may be a risk. For example, when the investor expects a dividend of Rs 15 per share and receives a dividend of Rs 20 at the end of the year, this deviation of Rs 5 is still considered a source of risk.
Because in that case, the reason why the actual income is higher than the expected income is unknown to the investor, hence it is also a risk.
Another example of risk is as follows. From the first of the two investments, we have made a profit of 10% for the last three years. From the second investment, we got 5%, 10% and 15% profit in the last three years.
Here the average profit earned by each of the two investments is equal or 10% but the first investment is risk-free and the second investment is risky. Because another concept of risk is the volatility of income. High volatility means high risk and no volatility means no risk.
The difference between risk and uncertainty
Although uncertainty creates risk, there are some differences between risk and uncertainty. First, not all uncertainties are risky. As mentioned earlier, the risk of something bad happening is a risk. But if we don’t know the probability of a bad event happening, then that uncertainty cannot be called risk.
In other words, the part of the uncertainty that can be measured is called risk. There are some uncertainties that cannot be measured.
For example, the death of the chief executive of a company is an uncertainty, but this uncertainty cannot be quantified. Hence such uncertainty cannot be termed a risk.
Second, since risk can be measured, risk can be mitigated by applying various strategies. But uncertainty cannot be reduced or avoided by applying various techniques.
For example, a company’s office building may collapse due to an earthquake, but the company cannot avoid this uncertainty because the earthquake is beyond the company’s control. On the other hand, there is a risk that the company’s sales will decrease next year. Because this risk can be measured and this company can adopt various strategies to reduce risk. Ex: Can sell in advance.
Source of risk
Every decision of a business organization involves some risk. Due to these risks, there is a possibility that the business organization may not get the desired results. As a result, the business has to manage these risks properly. It is important to find out the sources and classes of these risks for risk management. In this regard, the business context and the investor context are different. The sources of risk from different perspectives are discussed below.
From a business perspective:
a) Business Risks: Various operating expenses are incurred to run the business successfully. For example, purchase of raw materials, wages of workers, office rent, insurance costs, etc. The inability to pay these operating costs creates business risk. The ability of a company to meet its operating expenses depends on a combination of revenue from sales stability and operating expenses, i.e. the ratio of fixed and current expenses. If there is no stability in the sales income, i.e. if the sales income is high at some time and less at some time, there is uncertainty in meeting the operating expenses of the organization.
On the other hand, if the amount of fixed expenses such as office rent, insurance expenses, etc. is higher than the operating expenses, then the business risk is created. If the company raises funds entirely from internal sources i.e. the company has no external financing then this uncertainty regarding profitability is called business risk. The source of this is the change in sales price, change in sales volume, change in the cost of production materials, the trend of additional fixed costs, etc.
Financial Risk: This type of risk arises from financing from external sources. The higher the funds raised through loans, the higher the financial risk. Because it is mandatory to pay interest on loan capital. On the other hand, the distribution of profits is not mandatory if funds are raised from internal sources.
So if the business is not profitable when debt capital is used, then the lending institution can take recourse to the law and result in the liquidation of the business. The use of loan capital creates interest and liability to repay the said amount.
For example, if a company sells a 5 year term bond of Rs. 50 lakhs at 15% rate, it incurs an interest of Rs. Companies usually repay the borrowed capital with the cash flow received from the borrowed capital investment.
If for some reason the business does not receive adequate cash flow from the invested money, there may be an inability to repay the liability. If the debt is not paid for a long time, the lender can take legal action against the company and there is a risk of bankruptcy for the company. Consequently, the risk that arises from the inability to pay such liabilities is called financial risk.
From an investor’s perspective
a) Interest rate risk: Investors who buy bonds, debentures, etc., have to face interest rate risk. This is because, with the change in interest rates in the market, the value of their investment fluctuates. If the interest rate increases, the market value of these investments i.e. bonds and debentures decreases, while if the interest rate decreases, the market value of these investments increases.
Interest rate risk is the risk that the value of an investment will decrease due to changes in interest rates.
B) Liquidity risk: The investor needs to cash in on these investments at any time after investing in money shares, bonds or debentures, etc. It is hoped that the investor will be able to monetize these investments by selling them at a reasonable price. But if for some reason the investor cannot sell easily and at a reasonable price, then liquidity risk arises.
Liquidity risk generally depends on the size and structure of the market in which these investments ie: shares, bonds, debentures etc. are traded. Liquidity risk is much higher in monopoly and partnership businesses. This is because the movable and immovable assets of the business cannot be sold easily and at a reasonable price if cash is required.
On the other hand, when an investor buys shares of a company, he does not have to worry about liquidity risk. Because he can go to the secondary capital market or share market at any time and sell his shares if he wants. If an investor buys a company bond or debenture in the capital market, he has to think about liquidity risk. Because buyers of bonds and debentures are not as easily found in our secondary capital markets. So in that case monetizing the investment becomes time-consuming and expensive.
Significance of risk
Risk plays a special role in various business decision-making, which carries significant risk.
First, risk has an impact on the success of any company and its overall purpose. As mentioned earlier, the possibility of something happening beyond expectations is called risk. As a result, it is possible to avoid unforeseen losses by judging and analyzing the possible future events at the time of formulation of the business plan.
For example, a company is just bringing raw materials by river thinking of the benefits, he set up a factory on the banks of the river.
But unfortunately, after a couple of years in the tidal wave, the company will have to face huge losses if the factory is washed away in the river due to river erosion.
As a result, it will not be possible for the company to succeed. But if the company had considered this possibility in advance, it might have set up a factory right on the river bank and would have been considered a successful company.
Second: The profitability of the business organization depends on the market demand for the product. As a result, before starting a business, one has to analyze the market demand of each organization, estimate the realistic demand, and conduct and implement the business accordingly. The actual demand in the market may be more or less than the expected demand. If for some reason the actual sales are much less than the expected sales, it is not possible to make an adequate profit.
For example, An umbrella maker produces more umbrellas in anticipation of heavy rainfall during the monsoon season but if there is less rainfall later in the monsoon season, the umbrella maker’s umbrellas are likely to remain unsold. As a result, the company will not be able to earn the required profit. If the company had made some other products with umbrellas in this situation, the demand for those products might not have decreased even if the rainfall was less and the business could have achieved the desired profit.
Risk-free income and risky income
Not all incomes are risky, there are some incomes that are considered risk-free income. In other words, in such income, the actual income is always equal to the expected income. If you keep a fixed deposit in a bank, there is not much difference between the expected return and the actual return. It is a type of risk-free income. Income received from treasury bills and treasury bonds issued by the government of a country is considered risk-free income.
These investments are considered risk-free investments as they are issued by the government. Since the income from these risk-free investments is fixed, i.e. income is given at a fixed rate, the income received can be considered as risk-free income.
The risk is likely to be the difference between the expected income and the actual income. Part of the general income is risk-free and the rest is risky. Incomes that involve risk are called risky incomes. For example, when an investor buys a company’s common stock, there is no guarantee that future dividends will be equal to the expected dividends. The amount of dividend the company will pay in the future depends on the profit earned in the future years and other factors.
Therefore, the income from the said shares will be treated as a risk-bearing income for the investor. Even if the income is not fixed, the income from ordinary shares is considered as the most risky income.
Measurement of risk and uncertainty
Measuring risk is essential for successful business management. The risk arises from the deviation of the actual income from the expected income. The greater the deviation of actual income from expected income, the greater the risk, the smaller the deviation of income, the lower the risk. For this reason, the risk is measured from the deviation of expected returns and actual returns or the deviation of expected results and actual results.
There are different methods of measuring risk. Different methods are applied depending on the need or situation. In this step, we will look at the use of standard deviation to measure risk.
Standard Deviation: Just as risk is measured from the deviation of past earned returns using standard deviation, the risk is also measured from expected future returns. This is a statistical method. Below is the formula for standard deviation:
here,
∑(Income Rate-Average Rate)^2 = Sum of squared difference of average income rate from past earned income rate
n = number of years
Conclusion:
From all of the information above, it is clear that risk is an inevitable part of a business that cannot be avoided, while uncertainty is a decision-making tool that can be used to manage and improve the quality of operations. Knowing how to use these two concepts effectively can lead you not only to improved decision-making but also to increased profits. For this reason, it’s vital for every entrepreneur and manager to understand both concepts in detail so they can make well-informed decisions.
Related
