The Role of Risk in the Investment Decision Process: Traditional vs Behavioural Finance

Abstract

Risk and uncertainty exist whenever the future is unknown (Williams et al., 1997). Despite the intuitiveness of the concept, risk and its definition are still a debated issue in the literature. A first point to be discussed is the difference between risk and uncertainty. Knight (1921) maintains that risk refers to a situation for which the possible outcomes and their probabilities are known (measurable uncertainty); on the contrary, uncertainty exists when the probabilities associated to the outcomes are not known (unmeasurable uncertainty). In any case, not all academic authors agree on this distinction. Levy and Sarnat (1995) point out that, if one considers the existence of a subjective probability according to Savage (1954), the distinction between risk and uncertainty disappears. In fact, by assigning an individual subjective probability to decision problems, an uncertain situation can be transformed into a risky choice¹ and the distinction loses significance.