Risk can mean different things to different people. Most define risk as the possibility of loss. Note that we said possibility, not probability. Understanding the difference is key to how we make decisions about risks we face, but it can also be really hard to do.
How good are you at measuring risk? How do you decide if you should protect yourself against a risk or just ignore it? Are you even addressing the correct risk? If you get any of these questions wrong what is the cost? You may not have intentionally thought about this, but it is something you unconsciously do every day. Our goal here isn’t to give you a perfect formula for how to manage it (because one doesn’t exist), but it is to get you to think differently about how you make decisions surrounding risk in your everyday life.
How we make decisions
In Nobel Prize winning author Daniel Kahneman’s book “Thinking, Fast and Slow”, he describes two systems we use to drive the way we think. System One, or fast thinking, and System Two, or slow thinking.
System One is our automatic, unconscious decision-making mode. Emotional decisions fall into this category and it is heavily influenced by a wide variety of behavioral biases. This is what marketing companies live for. If they can get you to choose one brand of a product over all others without even thinking about it that is the pinnacle of marketing. Sometimes it is done with amazing storytelling, but also through the simple trick of repetition. The darker side of System One is where unconscious biases like racism, sexism, or other negative perceptions live. If you get a gut feeling about a person, experience, or product without knowing why that is your System One at work.
System Two is the slow controlled analytical method of making decisions. System two likes charts, numbers, and facts. This is our minds way of overcoming the biases that may be inherent in our first reaction, that is if we let it. When you see something you want on sale for 50% off System One screams “it’s a deal, buy it now!” but System Two does the math and realizes that it was just marked up 100% before being discounted. Purchasing crisis averted. System Two is not perfect though. As the old saying goes “There are three kinds of lies: lies, damned lies, and statistics.” Even when we slow down and engage System Two, we can make mistakes.
When we evaluate risks in our life, we are using one, or both, of these systems to identify, measure, and mitigate them as best we can. We feel that understanding the challenges we face in doing this will help us make better decisions about the risks we take, both financial and otherwise.
Identifying the risk
The first problem we face is being able to identify the risk correctly. Sometimes we mentally reframe the decision to something that seems easier to make, especially when we lack the skills System Two requires. Kahneman describes this in his book.
“This is the essence of intuitive heuristics: when faced with a difficult question, we often answer an easier one instead, usually without noticing the substitution.”
Imagine you were going to buy a stock, but you didn’t know how to read financial statements or evaluate a business. Instead you might change the question to how popular the company is, your personal feelings of its quality, and the average of online reviews for their product. Whether or not they have a great product is completely separate from if their stock is a good investment, but absent the skills to evaluate the stock on its financial merits we revert to measures we can understand. In your mind you did your due diligence and analyzed the company prior to making your decision while ignoring many of the real risks investing in an individual company comes with. Moving the goal posts makes us feel more confident, but it may lead us to identify the wrong risk.
The next problem is measuring the risk. Is it big or small? Is it frequent or rare (remember the difference between possibility and probability)? Is it direct or indirect? These questions help us decide the best course of action to address it. Measuring the risk incorrectly will lead you to the wrong solution to manage your problem.
Risk management is usually defined by major courses of action you can take to guard against them. You can retain the risk, control the risk, or finance the risk. Let’s briefly break these down with an example of each.
Retain the Risk: This is an example of you accepting the risk as is without taking action. Sometimes this is called self-insuring. If you bought a new cell phone in the last ten years you were probably asked if you wanted to buy insurance on it. By declining the insurance, you are retaining the financial risk that you might drop your phone and have to pay to replace or repair it. Declining any type of insurance without trying to reduce the probability or severity of the risk would be considered retaining the risk.
Controlling the Risk: You can attempt to control risk by using strategies like risk avoidance, loss prevention, or loss reduction. For example, wearing a seatbelt is an attempt to control your risk of serious injury or death. So is having a diversified portfolio so you don’t have all of your money invested in any one company. The most effective method of risk control is avoidance, but it may not be practical. Imagine saving enough for retirement while avoiding investing and only using a savings account.
Financing the Risk: This is best known by using insurance. You are transferring the financial risk to someone else (an insurance company) for a cost, or premium. This can also be done in investing through the use of options contracts.
You may try to combine these strategies to protect yourself even more, especially when you can only transfer part of the risk. Health insurance helps share the cost if you get sick or injured but combining that with living a healthy lifestyle reduces your chances of having to pay out of pocket to meet deductibles or copayments.
Generally speaking, we feel you should finance risks that you can’t, or would be unlikely to financially recover from. The most obvious is life insurance. If you die you have no way to earn more income. If your family needs your income to survive this is an easy decision to make. Because the loss is great, but the probability is low, at least for young families, life insurance can be an affordable way to finance the risk.
What if the risk is less severe but more common? This is where disability insurance fits in. It is estimated that around 25% of people will suffer a disability lasting more than a year prior to full retirement age. At first glance this seems like you would need it more than life insurance because it is more likely to happen. The difference is that this might not be permanent so you have a chance to regain your financial standing.
Whichever method, or combination of methods, appears to be the best answer rests on your ability to accurately measure the various risk variables.
The Cost of Mistakes
One final quote from Daniel Kahneman, “We can be blind to the obvious, and we are also blind to our blindness.” Said another way, we don’t know what we don’t know. What is obvious to one is revolutionary to another.
Sometimes lack of information, or knowledge, leads us to mistake the size or probability of a risk in our life. Other times it can lead us to believe that no risk exists at all. We want to share a question and story from author David Epstein that seems very relevant to today. One that involves misjudging risk because we did not understand how to measure it correctly. Here is the question.
If a test to detect a disease whose prevalence is 1/1000 has a false positive rate of 5%, what is the chance that a person found to have a positive result actually has the disease, assuming you know nothing about the person’s symptoms or signs?
For more context a 5% false positive means 5% of the time the test result came back positive, but they don’t actually have the disease and a prevalence of 1/1000 means we would expect one out of every 1000 people to actually have it in any population.
If you said someone who tested positive has a 95% chance of actually having the disease you would be in the majority, but unfortunately wrong. The correct answer is less than 2%.
If you are skeptical, and don’t mind a little math, you can calculate it yourself. Say 10,000 people in your town were tested. You would expect 10 people would actually have the disease (remember the prevalence of 1/1000). The test has a false positive rate of 5% (5% of 10,000 is 500). This means for every 10,000 people tested 510 would test positive (10 who really have it and 500 who had a false positive). Simple divide the number who have the disease by the total number that tested positive. 10/510 =.0196 or 1.96%
Imagine how you would feel. The stress, the worry, the fear. Now imagine you started making irreversible life decisions after receiving your positive test, only to find out later one positive test means you still have less than a 2% chance of truly having it.
David starts this story by saying that his doctor asked him if he wanted to take an antibody test for COVID-19 because he believed he may have already had it in February. His doctor told him the test had a 90% accuracy, or a false positive rate of 10%. You probably don’t feel so confident about that 90% accuracy rate now. Neither did he. Fortunately, the estimated prevalence of COVID-19 in the population is probably much higher, which helps. Unfortunately, the estimates still vary widely. Let’s look at two examples.
First, if we assume that 10% of the population has already had it (10/100 prevalence), and combine that with our 10% false positive rate the doctor provided, a positive test would mean there was a 50% chance you really had it (10/20=.50 or 50%). A coin flip. If we assume a much higher prevalence, like 20% (20/100), a positive test would mean there was a 67% chance you really had it (20/30=.666 or 67%).
Public health officials, companies, or individuals could make policy, employment, or health decisions based on assuming a level of immunity attributed to the positive test. As David explains “If we’re counting on antibody tests to tell people if they have some level of immunity, that could be a problem.” This is an extreme example but there are policy proposals floating around today that incorporate a positive antibody test at their core.
Understand Risk before you Manage it
Not all the risks in our life are that serious. When you take a short cut to work there is a risk it will take longer. When you try out a new restaurant there is a risk you will get a bad meal. These are 5 minute and $20 risks. These are not the ones to be concerned with. No, we want to spend our mental and physical energy understanding the life altering risks. Not managing the risk of your investment portfolio to match your time horizon could force you to work several extra years before you can retire. Deciding to go without health insurance when you’re young could easily cost you $50,000+. These are years and bankruptcy problems.
When dealing with risks, that if realized would be devastating to your financial situation, please make sure you fully understand them. Seek out experts in the field who have looked at the problem from multiple angles. Research possible ways to mitigate the risk and evaluate the different costs to each. Finally, go slow and take your time. Life is a marathon, not a race.