Why you suck at assessing risk

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28 Mar Why you suck at assessing risk

In the months after September 11, 2001 attacks in the US, the number of people travelling by air declined. Terrified of flying, many travellers revved up and drove to their destinations instead of flying. This increase in car travel resulted in an additional 1600 driving fatalities in the three months immediately after the attack, according to one researcher.

This is one example of how our incorrect perception of risk causes us to act in ways that increases the danger that we’re trying to avoid in the first place.

As humans, we suck at assessing risk. We’re scared of high profile, low probability events such as terrorist attacks and plane crashes, but we ignore more mundane threats such as a car accident or unhealthy eating. If you live in the developed world, you’re 30,000 times more likely to die of a heart attack or cancer than a terrorist attack. But for many people it may feel as though we worry more about a possible terrorist attack than falling ill.

Psychologists have identified a mental shortcut know as ‘Availability Heuristic’. This is our natural tendency to rely on immediate examples that come to mind when evaluating a specific topic, rather than the reality that’s supported by data or statistics. The result of this is that we tend to place more weight on high profile dangers publicised by the media because they’re easier to recall, as opposed to the more mundane dangers that we confront on a daily basis.

Take another example. Many investors pay too much attention to financial news. By its very nature, this is likely to focus on negative events in the capital markets. You’re very likely to see headlines reporting ‘billions wiped off the stock market’ but when did you ever hear of ‘billions wiped onto the stock market’? As a result, investors live in constant fear of a possible stock market decline. And rather than sit tight during periods of temporary market decline, some sell their investments and in the process turn a paper loss into a permanent loss, the very thing they’re trying to avoid in the first place.

This is yet another reason why we at Tandem believe that our job isn’t just to manage investments, it’s also to help manage investor behaviour. It’s our job to make sure our clients understand all the investment risks. When the capital markets take a bad turn, as they occasionally do, we make sure our clients avoid knee-jerk reactions which can often turn a temporary market decline into a permanent investor loss!