Inaccurately assessing risk when it comes to your finances, health and career can have major consequences when it comes to your life and relationships. In fact, a study from AAA found that 73% of Americans reported themselves to be above-average drivers, while statistically over 90% of car accidents were the result of user error.
Clearly there exists a mismatch between how people perceive risk versus how much of a factor risk actually plays in our lives. This can affect everyday decisions, like deciding whether to buy too little, or too much insurance, or gauging your ability to make payments on that brand new car or home.
According to the CFA Institute, “risk management is the process by which an organization or individual defines the level of risk to be taken, measures the level of risk being taken, and adjusts the latter toward the former, with the goal of maximizing… the individual’s overall satisfaction, or utility.”
We dive into the reasons why people are inherently bad at assessing risk, and the steps you can take to improve your decision making when uncertainty is involved.
Why are people bad at measuring risk?
Studies in behavioral psychology show that individuals are often irrational when it comes to making decisions as well as assessing the risk/rewards of those decisions.
A classic example involves the purchase of lottery tickets. Surveys have shown that ticket scales increase exponentially as the size of the jackpot increases. Larger jackpot sizes are proven to increase lotto sales, despite this having no impact on your chances of winning.
This is known as anchoring bias in decision making, where an arbitrary reference point is relied on for a decision, often having little to no actual bearing on the actual decision.
Another common example involves the perception of value versus scarcity. The majority of crypto investors are more likely to buy up cryptocurrencies at any given price when the price of bitcoin skyrockets. However, when the price crashes, momentum swings the other way and there’s a deluge of investors looking to sell at all prices.
This is a textbook illustration of the hot streak fallacy in crypto investing, which combines aspects of both overconfidence and trend chasing behavior among investors.
In both cases we illustrated, the risks were understated while the expected returns were overemphasized. While on paper, the right answer may seem obvious, but in the heat of the moment, many of us are just as likely to exhibit the same behavioral biases as everyone else.
How should you think about risk management?
It’s hard to challenge one’s psychological predispositions, but it starts by understanding the process of risk management and how we think about everyday decisions.
1. Define the risks
When faced with any decision, you’ll want to first assess the consequences that might be associated with that decision, both positive and negative. Defining the risks specifically encompasses dissecting all the possible outcomes you can identify.
Much like creating a list of pros and cons of each decision, this step involves getting a lay of the land and a full understanding of all possible outcomes. While this isn’t always possible, it’s wise to take a second to gauge the consequences of your decision before making it.
2. Measure the risk
This involves vetting the list of risks you’ve identified and measuring the possible impact of each risk. When measuring each risk, you’ll want to assess your risk exposure, the probability of that risk occurring, and the potential impact of that risk, should it occur.
This step requires you to dissect the risks and benefits you’ve amassed in step one, and weigh them against each other. While this requires some deeper thought, it helps you think through the gravity of each possible result and its likelihood of occurring.
3. Adjust your risk exposure
The final step of the risk management process involves adjusting how much risk you face through one of two actions, 1. Risk avoidance and 2. Risk mitigation.
Risk avoidance is the simple act of precluding yourself from exposure to that risk, or otherwise reducing or eliminating the possibility of that risk ever occurring. For example, a first-time investor worried about the possibility of a company going out of business can avoid that risk by choosing not to buy it.
By contrast, risk mitigation involves the act of reducing the negative outlays that may occur, even if the risk does occur. Buying a well-funded insurance policy is a classic example of risk mitigation, as it reduces the amount of out-of-pocket expenses you might face in the event of a disaster.
When to apply risk management
Risk management can be a useful framework when evaluating both professional and personal dilemmas. Given its origins, it’s also an ideal way to approach your financial decision making. When you’re assessing your plan for the future, are you making sure your decisions are adequately rewarded for the level of risk you take?
However, readers shouldn’t let risk management get in the way of their life goals, particularly when it comes to one’s dreams or aspirations. The downside of risk avoidance is that it eliminates any possibility of you partaking in any upside, particularly when the payoffs are high.
Knowing when and where to apply these concepts is just as important as understanding the concepts themselves. We’ll do a deeper dive of risk/reward dynamics, particularly when they involve new technologies, in our next piece. Stay tuned!