The importance of risk & loss
Posted by John Humphreys on March 3, 2007
Risk is caused by lack of knowledge. Taking risks increases knowledge and increasing knowledge involves risk. Risks include changes in competition, technology, interest rates, exchange rates, preferences, policy etc. All business choices (including keeping the status quo in an equilibrium) involve risk.
One motivator for investing in knowledge is to achieve an economic gain. But an alternative motivator is to avoid an economic loss. Any action that removes the inherent risk of business from the businessman (ie government bail-outs) decreases the incentives of business to look for new knowledge.
The degree of risk aversion (willingness to accept risk) helps to determine the amount of investment and the expected return on investment. Less risk aversion = more investment = higher returns. The returns will be higher for two reasons: compensate for higher risk (therefore same expected return); and because no reason to avoid best return strategy (move to higher expected return).
Hayek understood the links between risk (uncertainty) and knowledge (discovery).
Hayek: “the results of a discovery procedure are necessarily unpredictable, and all we can expect by employing an appropriate discovery procedure is that it will increase the prospects of unspecified persons, but not the prospect of any particular outcome for any particular persons”
In other words — before the race, nobody knows who the winner will be. That is why they race.
