Knightian Uncertainty

What is Knightian uncertainty?

One of the critical aspects of Risk Management is to identify risk. Part of the risk identification process is to filter risks into degrees of being known or unknown. One of the critical categories of risk is known unknowns, also referred to as Knightian uncertainty).

Example of Knightian uncertainty

Various risks can be classified as Knightian uncertainty. One such risk is reputational risk. We know that all organisations, especially the public ones, face some reputational risk which is a known risk. However, we know little about the impact of reputational risk, which cannot be modelled through conventional risk measurement models.

Why is it essential to know Knightian uncertainty?

The known unknown risks are probably the most relevant category of risks. It tells us that there is a particular risk that can only be accepted, and there isn’t much we can do about it in quantifying and managing it. Knightian uncertainty, also known as “unknowable unknowns,” refers to risks that cannot be quantified or measured because of a lack of historical data or understanding.

This type of uncertainty is different from known risks, which can be modeled and predicted using probability-based tools. An example of Knightian uncertainty is the potential impact of a completely new and unknown technology or market disruption. As there is no precedent or historical data, it is impossible to predict the probability or impact of such a risk using conventional models.

It is crucial to understand Knightian uncertainty because it highlights the limitations of risk management models and tools. Although risk management techniques such as scenario analysis and stress testing can help identify potential risks, they cannot predict or quantify Knightian uncertainties.

Identifying and accepting the presence of Knightian uncertainty is an essential part of effective risk management. It reminds us that there are always unknowns and uncertainties in any complex system or decision-making process, and it is impossible to eliminate all risks. It is crucial to understand and manage the risks we can control and accept the risks we cannot. Accepting unknown unknowns and preparing for them is crucial to creating a more robust risk management framework.