Risk Assessment – And Why You Stink at It

 
 

You stink at assessing risk. There, I said it. The thing is, I stink at assessing risk, too. We all do. If you watch “Shark Week,” for example, you will likely be petrified of the ocean even though your pajamas are more likely to catch fire than a shark is to attack you. People are prone to (at least) six errors in judgment when appraising risk.

Learn them. Then try to avoid them.

Reason I: The Availability Heuristic

Name all the words you can that begin with the letter K. Go on, I’m not listening. How many were you able to come up with? 
Now, name all of the words you can in which K is the third letter. How many could you name this time?

If you are like most people, you found it easier to generate a list of words that begin with K; the words probably came to you more quickly and were more plentiful in number. But, did you know that there are three times as many words in which K is the third letter than there are that start with K? If that’s the case, why is it so much easier to create a list of words that start with K?

It turns out that our mind’s retrieval process is far from perfect, and a number of biases play into our ability to recall. Psychologists call this fallibility in your memory retrieval mechanism the “availability heuristic,” which simply means that we predict the likelihood of an event based on things we can easily call to mind. Unfortunately for us, the imperfections of the availability heuristic are hard at work as we attempt to gauge risk.

In addition to having a memory better suited to recall things at the beginning and the end of a list, we are also better able to envision things that are scary. I know this first hand.

Roughly five years ago, I moved to the North Shore of Hawaii along with my new wife for a six-month internship. Although our lodging was humble, we were thrilled to be together in paradise and eager to immerse ourselves in all the local culture and natural beauty it had to offer. That is, until I watched “Shark Week.”

For the uninitiated, “Shark Week” is the Discovery Channel’s seven-day documentary programming binge featuring all things finned and scary. A typical program begins by detailing sharks’ predatory powers, refined over eons of evolution, as they are brought to bear on the lives of some unlucky surfers. As the show nears its end, the narrator typically makes the requisite plea for appreciating these noble beasts, a message that has inevitably been overridden by the previous 60 minutes of fear mongering.

For one week straight, I sat transfixed by the accounts of one-legged surfers undeterred by their ill fortune and waders who had narrowly escaped with their lives. Heretofore an excellent swimmer and ocean lover, I resolved at the end of that week that I would not set foot in Hawaiian waters. And indeed I did not. So traumatized was I by the availability of bad news that I found myself unable to muster the courage to snorkel, dive or do any of the other activities I had so looked forward to just a week ago.

In reality, the chance of a shark attacking me was virtually nonexistent. The odds of me getting away with murder (about 1 in 2), being made a Saint (about 1 in 20 million) and having my pajamas catch fire (about 1 in 30 million), were all exponentially greater than me being bitten by a shark (about 1 in 300 million). My perception of risk was warped wildly by my choice to watch a program that played on human fear for ratings and my actions played out accordingly.

Reason II: The Affect Heuristic

One of the reasons psychologists can charge $200 per hour to ask, “how does that make you feel?” is because we have become great at putting fancy-pants labels on things that would otherwise be very intuitive. Take for instance the tongue-twisting “affect heuristic,” which is simply a reference to our tendency to perceive the world through the lens of whatever mood we are in.

For example, when giving a seminar on risk assessment, I often ask participants to write down the word, that if it were spelled phonetically, would be “dahy.” Go on, write it down and don’t overthink it. It turns out the way you spelled the word has a lot to do with the kind of day you are having. Those that spelled the word as “die” may need a hug, while those that spelled the word “dye” are probably doing fine.

Ask someone having a bad day (those that wrote “die,” I’m looking at you) about their childhood and they are likely to tell you how they were chubby, had pimples and never got picked first for kickball. Conversely, ask someone having a good day about their childhood and they are likely to recall summers in Nantucket and triple dips from the Tastee Freeze. Memory and perception are moving targets colored by our mood, not infallible retrieval and evaluation machines through which we make unbiased decisions.

So what is the moral of all of this psycho-babble? Think back on the last time you went shopping when you were hungry. Once you’ve brought that to mind, think back on the contents of your shopping cart. If you’re like me, you probably had a whole mess of HoHos, Ding Dongs, Nutty Buddies and Diet Coke (you don’t want to get fat, after all), but nothing very healthy or substantive.

The same rules apply to any decision requiring risk assessment; if you try to make decisions when you are happy/sad/angry/in love/anxious/worried/euphoric, you are likely to end up with a portfolio full of junk food. So, the next time you are about to make a decision in a fit of rage (or right after getting engaged), take a step back, breathe deeply and let time bring you back down to Earth. After all, shopping while you’re hungry can make you sick.

Reason III: The Illusion of Control

People have a vested interest in feeling competent and in control. In fact, the definition of stress that I find most useful is “the loss of perceived control over an event.” So while the obvious upside of this tendency to feel in control is a perception of personal competence, the downside is that we tend to think we can control random events as well.

Let’s say I offered to sell you a lottery ticket with a 1-in-50 chance of winning a prize. How much would you pay if I assigned you a number randomly? Now, how much would you pay if I offered to let you choose your number among the 50 available, allowing you to pick your daughter’s birthday?

When psychologists run this experiment, people pay $1.96 on average for the tickets that are given to them and $8.67 on average for the tickets for which they are allowed to choose the number. Obviously, the odds are the same in both conditions (1 in 50), but our confidence that we control the universe is such that we are willing to pay 4.5 times more to be in charge.

Another example of our propensity to overvalue our own influence is the tendency of people to over-invest in their own organization’s stock for the stated reason that they can directly impact the stock price. So, Suzie from accounting is going to invest in Coca-Cola because she feels the valuation of the world’s greatest brand lives and dies on the skill of her bean-counting. Unfortunately, if you — in isolation — can directly impact the rise or fall of your stock, and make personal investment decisions accordingly, you might be going to jail soon. For the rest of us peons, our daily travails do not matter much one way or the other in the ultimate success or failure of a publicly traded company and it is best not to invest as though they do.

Reason IV: The Illusion of Uniqueness

Is your spouse out of the room? Good. Now, let your mind wander for a second back to your first high school love. Do you remember how intense your feelings for them were? Do you recall that sick feeling in your gut when you were apart from them? The profound, undeniable sense you had that no one had ever experienced a love as deep or as pure as what you were now feeling for John Q. Quarterback or Jane Q. Cheerleader?

But along the way, something happened and your love went unrequited. You searched for solace from friends, siblings, parents, perhaps even a shrink, all to no avail. Because no matter how many trees you killed in Kleenex form and no matter how many times you told the story of your heartbreak, no one ever got it. How could they after all? Mere mortals could never understand the unique splendor of what you had experienced with your Schnookums. Psychologists call this illusion of uniqueness “personal fable,” and it hurts those trying to assess risk at least as much as heartbroken adolescents.

Cook College performed a study in which people were asked to rate the likelihood that a number of positive events (e.g., win the lottery, marry for life) and negative events (e.g., die of cancer, get divorced) would impact their lives. What they found was hardly surprising — participants overestimated the likelihood of positive events by 15% and underestimated the probability of negative events by 20%.

What this tells us is that we tend to personalize the positive and delegate the dangerous. I might win the lottery, she might die of cancer. We might live happily ever after, they might get divorced. We understand that bad things happen, but in service of living a happy life, we tend to think about those things in the abstract.
The risk management implications of perceived uniqueness are obvious — if we make decisions with the mind-set that we are a unique snowflake, we are likely to ignore potential risks. And if we think we are unique, we inevitably ignore lessons from history and from watching others. Worse still, if we perceive upside potential to be “all us” and losing to be the birthright of those other schmucks, we are bound to do stupid things.

Reason V: Groupthink

I am privileged to be a part of the speaker’s bureau for Guardian/RS Funds and recently found myself with members of the RS team in San Antonio, Texas, for the Advisor Group Women’s Conference. Before my presentation on “The Art and Science of Persuasion” the next day, a few of us decided to grab dinner along San Antonio’s historic River Walk. The River Walk is beautiful; tucked one level below the street and lined with restaurants, shops and hotels, it offers no shortage of options for the hungry traveler in search of some authentic Tex-Mex cuisine. After meeting my colleagues at a nearby hotel, we began to wander the labyrinthine streets, passing a number of excellent restaurants but never stopping to eat.

Having not determined any clear criteria for selecting a dinner spot, we continued to wander until we were accosted by an enthusiastic host at a garish Mexican restaurant. After rattling off a list of run-of-the-mill Tex-Mex offerings, he moved on to describing the house drink specials, which sounded similarly unspectacular. So how was it, that just moments later, our five-person party of foodies was seated at a sticky table at this culinary also-ran?

The answer lies in our propensity to try and read others’ minds and act in ways that are consistent with their desires — somehow, someway, everyone in our party got the idea that everyone else in the party wanted to eat at this tacky dive and dared not speak up, lest they offend the others. The result was what social scientists call “mismanaged agreement,” something illustrated by the classic management tale of “The Abilene Paradox,” in which a family drove 100 miles in the scorching Texas heat to eat bad food when all of them really just wanted to stay home.

Our tendency to want to read minds and our inability to do so can result in something much more dire than a stomach full of stale chips, however. This propensity to engage in groupthink is the sort of behavior that creates and eventually bursts financial bubbles.

As a student of human behavior, there are precious few things that I would state as approximating a law. One of the few ideas that come close for me is that people are cognitively lazy and will consistently use decision-making rules of thumb rather than reinvent the decisional wheel each time. After all, every day of your life is filled with decisions to be made. Diet Coke or Diet Pepsi? Should I exercise or stay in bed? Do I wear the black or the grey suit?

Without heuristics, or experience-based rules of thumb for making decisions, life would become paralyzing and we would get very little done. Although there is considerable upside to decision-making heuristics, one of our most common fallbacks is to rely on the decisions of others, a trend that can lead us to make poor decisions.

For another example, consider the last time you were asked for money by a person on the street. Perhaps this individual approached you with a cup or a tin, which may or may not have had any money in it already. Stop for a moment and consider who you would more likely donate money to — a person whose cup was empty or someone whose cup showed evidence of the generosity of previous passersby? It seems intuitive that, all other things being equal, the person with the least money in their cup is the one more deserving of your largesse. After all, if they are begging, they may not have adequate financial means to meet their basic human needs. The less money they have, the more they could benefit from your donation, right?

This being the case, why is it that researchers consistently find that passersby give more money to those whose cups already have money? The answer is simple — an empty cup is seen as a judgment of unworthiness by previous onlookers. Although we may not fully comprehend all of the reasons they are unworthy of our donation, we are likely to follow the lead of those who have gone before and withhold our offering. Switch gears here with me — by basing our decision on the decisions of others, we have overlooked a logical component of decision-making (in this case, need) and relied instead on a choice strategy that may have little to do with what ought to be our primary concern.

These are all the ways in which groupthink can lead us to make unsatisfying decisions (like nasty salsa) and illogical decisions (like helping the wrong person asking for money). But can it also lead us to make risky decisions? Prior to the 1980s, the conventional logic said that when groups of people got together, the decisions they made would look something like the average of the risk tolerance of the group as a whole.

However, what research has borne out time and again is that groups tend to make decisions that are far riskier than the decisions that would be made by the individuals themselves. It turns out that as group size increases, the perceived responsibility for outcomes lessens. With this lessened degree of felt responsibility, it becomes easier to make decisions that may risk personal or financial well-being, since after all, it wasn’t just my decision.

Reason VI: Loss Aversion

The year is 2012. All of those Mayan calendar people you thought were wackos turned out to be right, and the world as we know it is falling apart. Zombies roam the countryside, infecting people with a heretofore unknown disease.

Imagine you are the mayor of a town and you have been approached with two plans. You must make a choice that will have far-reaching implications for the 600 citizens of your once-fair land.

If you adopt Plan A, 200 people will be saved. If you adopt Plan B, there is a 1-in-3 chance that all 600 citizens will be saved but a 2-in-3 chance that none will be saved.

Which decision would you make, mayor? Before you answer, consider two other plans that your vice-mayor just now constructed. If you adopt Plan C, 400 people will die. If you adopt Plan D, there is a 1-in-3 chance that no people will die but a 2-in-3 chance that 600 people will die.

So, which plan did you initially choose: A or B? What about from the second set of alternatives: C or D? If you are like most people, the decisions you made have a great deal to do with your fear of loss.
If you take a minute to consider the options, you will notice that options A and C are identical probabilities, as are B and D. That being the case, why is it that people choose A over B at a 3-to-1 ratio, and D over C at a 4-to-1 ratio? It doesn’t make sense, does it? Until you consider the framing of the questions — questions framed as a loss are avoided in both cases. Social psychologists who study loss aversion find that people are typically twice as upset about a loss as they are pleased about a gain.

I’m sure it took a decade and millions of dollars to tell you what my dad, a financial advisor with Morgan Stanley/Smith Barney, could have told you. His phone doesn’t ring much when he is making people money, but he got a lot of calls in 2008 and 2009.

It goes without saying that no one likes to lose money; in this sense our fear of loss is natural and can be protective at times. However, it can also be damaging at times when it distorts our view of the world or leads us to not even play the game.

Consider the most meaningful thing you have ever done. I would wager it took a measure of risk, uncertainty and hard work to achieve. In this, as with all risk assessment, comes a valuable lesson: to strive for certainty is to doom oneself to mediocrity. The irony of obsessive loss aversion is that our worst fears become realized in our attempts to manage them.

 
Dr. Daniel Crosby

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About the Author

Dr. Daniel Crosby is an organizational psychologist whose clients include Morgan Stanley/Smith Barney, RS Funds, Grant Thornton and Appleton Learning. This article was originally published as a post series on Crosby's blog Bullish Brain.

 
 

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