Why We're Awful at Assessing Risk

Like most of you, I've been glued to news of the missing (as of this writing) Malaysian Airways jet for the last few days. It's a gripping story. Mixing tragedy with mystery is impossible to ignore.

For the families of the missing, this is a terrible ordeal. For the rest of us, there's something strange about how we cover events like the missing plane in the news.

Flight 370 disappeared Saturday with 239 people aboard. Using annual averages, 10,500 people have likely died from malaria since then. Four thousand have died from traumatic injuries, and 16,500 from tuberculosis. In America alone, 9,900 people have died of heart disease since Saturday. Just under 600 died in car accidents. Two hundred and fifty were likely murdered.

Yet virtually none of their stories made the news, and not a single one drew anywhere near the attention that Flight 370 has.

Most of us have a flaw when reacting to risk: Threats like plane crashes, which are statistically insignificant but rare, grab our attention and scare us more than those that are deadly serious but common, like heart attacks and car accidents. The gap between the things we worry could happen and what's actually happening around us can be huge. Some estimate that as many as 20,000 Chinese coal miners die each year, nearly all without a word from the media. But if one died in a nuclear power accident, it would be global news for decades. If the U.S. news focused on the biggest threats we face, it'd write about almost nothing other than poor diet, lack of exercise, and car accidents -- which are probably three of the least covered topics.

Coming to terms with the fact that nearly all of us are bad at assessing risk is vital to managing money. This is especially true because money is emotional, taboo, and many of us are financially illiterate and borderline innumerate.

Paul Slovic runs the Decision Research Institute in Oregon. He's spent his career studying how people judge risk. Slovic's research shows that people overestimate risk when a danger has a handful of qualities, including:

  • Catastrophic potential: Lots of people affected at once, rather than in small numbers over time.
  • Familiarity: A risk that isn't common knowledge.
  • Understanding: A sense that something isn't well understood by experts.
  • Personal control: A sense that danger is outside your control.
  • Voluntariness: Something can do harm even when you don't voluntarily put yourself in danger.
  • Children: Mention the word children, and panic multiplies.
  • Victim identity: As Joseph Stalin said: "One death is a tragedy; one million deaths is a statistic."
  • Origin: Man-made risks are viewed as more dangerous than natural disasters.

You can imagine how these fit into finance.

People dread a big market crash because it affects everyone at once, but pay little attention to our abysmally low savings rate, which ruins individual people's financial lives slowly over time. We panicked over the flash crash in 2010, not because it was a big deal, but because it was a new, mysterious risk that we knew little about. And when you hear anecdotal stories about individuals fleeing the stock market in 2008, it sounds much more distressing than the reality of 97% of investors not fleeing the market in 2008.

In all of these cases, people focus on the wrong risks -- or overestimate risk and damage happening around them -- which leads to overreaction at the worst possible time. The best example of this comes from German professor Gerd Gigerenzer, who showed that the increase in car travel stemming from people's fear of air travel directly after 9/11 likely led to an increase in traffic fatalities measured in the thousands, and possibly more than the number of actual 9/11 victims. There's hindsight bias in that observation, but obsessing about a small risk while ignoring a much larger one is par for the course in human behavior. "People jump from the frying pan into the fire," Gigerenzer wrote.

In investing, high-profile risks that we talk about all the time, like whether stocks are going to fall next month or whether a company is going to miss quarterly earnings, aren't nearly as dangerous as the slow-burning risks we habitually ignore. Take these three.

1. Fees
Vanguard shows that if your investments earn a 6% annual return, a 1% management fee will reduce your account balance by half over 50 years. I can't imagine how many investors would shriek at a possible (and temporary) 50% market crash, but don't bat an eye at a fee that will guarantee them the same result with no chance of recovery.

2. Trading too much
Investors who do the least will likely do the best over time. For the huge majority of people, investing a set amount of money each month consistently over a long period of time will outperform any trading strategy they attempt. The evidence on this is overwhelming. It's so overwhelming that I think the single biggest risk you face as an investor is that you'll try to be a trader. It's the financial equivalent of drunk driving -- recklessness blinded by false confidence. "Benign neglect, bordering on sloth, remains the hallmark of our investment process," Warren Buffett once said. It probably should be yours, too.

3. Not saving enough
The personal savings rate is currently about 4%, which is half its long-term average. That statistic poses a way bigger risk to people's finances than the numbers that get thrown around showing how overvalued the stock market is. Most people spend too much time trying to become a better investor and not enough time trying to save more money. That's especially true if you're young. As the saying goes, "Save a little bit of money each month, and at the end of the year, you'll be surprised at how little you still have."

More financial misery has been caused by ignoring these three risks than has in nearly all the irrelevant risks the investment media writes about all day long. Not realizing this is why most of us are bad at assessing risk. 

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

 


Read/Post Comments (17) | Recommend This Article (51)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 14, 2014, at 2:40 PM, nasis wrote:

    How does the link in the "Trading too much" section

    http://www.valuebygeorge.com/wp-content/uploads/2012/05/Dalb...

    relate to trading frequency? Can you point us at the paper?

  • Report this Comment On March 14, 2014, at 2:59 PM, TheDumbMoney wrote:

    Preach it.

  • Report this Comment On March 14, 2014, at 3:06 PM, TopAustrianFool wrote:

    Why? Because you know little about economics. And since as an investor, you are usually trying to asses risk in business ventures that are not your own, your lack of understanding of economics doesn't let you asses the risk involved with monetary policy. Also since you have no idea that value is subjective, most of your valuations in dollar terms are a completely useless and based on adulterated prices and folly.

  • Report this Comment On March 14, 2014, at 3:12 PM, TMFHousel wrote:

    nasis,

    Thanks for the comment. The average individual investor earns far less than the market because they're constantly buying and selling, usually at the wrong times. Those who stick with it through thick and thin typically do the best over time.

    Research firm Dalbar calculates these numbers. See more here:

    http://www.qaib.com/public/downloadfile.aspx?filePath=freelo...

    Thanks,

    Morgan

  • Report this Comment On March 14, 2014, at 3:18 PM, Mega wrote:

    "One death is a tragedy; one million deaths is a statistic."

    I prefer Mel Brooks: "Tragedy is when I cut my finger. Comedy is when you walk into an open sewer and die."

  • Report this Comment On March 14, 2014, at 3:20 PM, TMFHousel wrote:

    Good call mega.

  • Report this Comment On March 16, 2014, at 10:16 PM, TMFTopDown wrote:

    You always know how to put it into perspective, Morgan. Great work, as always.

    -Steve

  • Report this Comment On March 17, 2014, at 8:26 AM, nelson65 wrote:

    Insightful article.

    However, the author overlooked one of the most effective tools in saving over the long haul - owning one's home and/or other real estate and it fits Buffett's long term strategy.

    Put a pencil too it - look up your amortization schedule.

    Most of us don't even know how much of that fixed mortgage pymt we make every month goes to principal.

    Like my dad use to say, "Houses don't have any wheels."

    Respectively,

  • Report this Comment On March 17, 2014, at 8:43 AM, TMFHousel wrote:

    Nelson,

    I have to disagree. The average home is financed with a 30-year mortgage and owned for 8 years. During the entire time they own the home, no more than 30% of the monthly payment is going toward principal. During the early years, more than 85% of a mortgage payment goes toward interest. Most people I know who own a home do so because they think their payments go toward equity, whereas renting is "throwing your money away." Many don't realize that the vast majority of a mortgage is just renting money from a bank.

    It's different if you can own a home for 10, 15, 20 years. But few Americans do.

    -Morgan

  • Report this Comment On March 17, 2014, at 10:04 AM, nelson65 wrote:

    I'm a first time contributor and thank you for your response. I came about your link by accident and did find it "enriching." I intend to "follow" your articles.

    My opinion came from a different angle - shelter is one of our primary instincts and what better way to do it than through home ownership.

    Even though it is "borrowing" from a Bank, isn't that better than sending it into "a black hole" via a landlord?

    And isn't the long term aspect of home ownership in keeping with the primary message of your article?

    Again, thank you for your reply.

    Respectively,

  • Report this Comment On March 17, 2014, at 2:17 PM, bamasaba wrote:

    I think that one risk people greatly overreact to these days is identity theft. For some reason I cannot fathom people seem deathly afraid of it, probably for most of the reasons you highlight in this article.

  • Report this Comment On March 17, 2014, at 9:09 PM, lwbaum wrote:

    Great point, Morgan! Working in health research and being a news junkie made me aware of this and prompted me to try to do something about it. Maybe a news website focused on poor diet, lack of exercise, and car accidents:

    http://ideaexplore.net/news

    My hope is that viewers would develop priorities better reflecting the things that really affect people, and that a better informed public would vote and make other decisions that use the world's limited resources more efficiently to help our lives. I've been too busy with my day job to update it recently, but I'd love to pursue this somehow if you have ideas for involving real journalists.

  • Report this Comment On March 18, 2014, at 7:50 AM, jacktyson wrote:

    It is the same people who nit pick your message that easily fall into the articles references. I believe they can't understand they need to step back and see the scope of what your saying and how that relates to the 99%.

    Great article by the way.

    Thanks

  • Report this Comment On March 18, 2014, at 5:53 PM, jpollar wrote:

    I would think marriage (male slavery) would be at the top of this list for men. You're gambling that you won't be financially wiped out (lose 50% of your assets), lose your children (90%+ of custody is awarded to the female) or go to prison (our culture only jails men for failing to pay child support and alimony) when she decides to terminate the contract (73% of all divorces are filed by the female).

    That to me is way more risky than paying a few extra fees.

  • Report this Comment On March 19, 2014, at 12:02 AM, sliderw wrote:

    That people pay attention to the Malaysian flight mystery has nothing to do with risk. It is a bad opener for this article. People pay attention to it because it is unusual, not because they misjudge the risk of a flight crash.

  • Report this Comment On March 19, 2014, at 12:02 AM, sliderw wrote:

    That people pay attention to the Malaysian flight mystery has nothing to do with risk. It is a bad opener for this article. People pay attention to it because it is unusual, not because they misjudge the risk of a flight crash.

  • Report this Comment On March 19, 2014, at 11:27 AM, FoolTheRest wrote:

    Good God, I hope jpollar works on a first floor and doesn't have any bridges on the way home.

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