Risk

I’ve been slacking lately, but it’s time to get regular again! Today we talk about an important topic that as we’ll see, we all don’t really understand well: risk.

Consider this anecdote from the amazing book Freakonomics. An 8 year old girl has two friends that she likes to hang out with. Her parents know that friend A has a gun in the house, whereas friend B does not. So, the parents don’t really let her hang out at friend A’s house and instead let her hang out at friend B’s. They are concerned about the safety of their child. Friend B, however, has a pool at her house. Children under 10 are about 100 times more likely to die from drowning in a pool than they are from a gun (adjusted for the number of pools and guns in the US), so really her parents are putting her at a much higher risk of death by choosing friend B’s house over friend A.

Another example is the fear of flying over driving. Post 9/11, there was an increase in driving and a simultaneous decrease in air travel. Given the timing, it’s reasonable to assume that people were driving instead of flying for fear of another terrorist attack. But driving is inherently much more dangerous than flying on a per-mile basis. In fact, even in 2001 which was a freak year in terms of flying-related deaths, flying was still only one eighth as dangerous as driving! In the months after 9/11, one researcher estimates that an additional 1600 people died trying to avoid a terrorist attack by driving instead of flying.

The problem in both of these cases is that humans are bad at assessing riskWe suffer from at least three ailments. First, we feel like things under our control are less risky, which in some cases is simply not true. Driving seems like it’s under your control, but even if you think you’re an above average driver (as I’m sure the majority of the population does), the risk of an accident in a car is much greater than in a plane. There’s also the familiarity factor. We know what pools are like and enjoy them regularly. We probably don’t think of them as deadly like we do guns. But the data tells us that they are actually much more deadly. Finally, we suffer from recency, or over-weighing things that happened in the recent past.

A great example of recency comes from looking at different generations’ investment preferences. People who came of age during a recession are much less likely to prefer investing in stocks than people who came of age during a boom. But, really, when you came of age has absolutely no effect on future stock returns, which as we know cannot be predicted anyway. Since stocks are, historically, the best asset class to invest in, we should take advantage of that regardless of what happened in that small subset of the past that we may be familiar with.

Indeed, learning how to conduct an honest assessment of risk can make our lives both safer and more profitable. Consider the ultra-commuter who drives an SUV to work every day because it seems safer, even though some studies have shown that sedans are actually safer than SUVs. But really, the best way to mitigate the risk of an accident is to drive less by living close to work. Since driving is also a very expensive activity, living close to work is often the much more profitable choice as well.

So, when you’re deciding what car to drive, where to live, or how to raise your kids, consider whether or not you’re assessing risk fairly. Don’t pay a premium for the illusion of safety and end up with neither safety nor financial stability (we haven’t even brought up the risks of not working toward financial independence!). If you can understand risk and use it to make sound life decisions, you’ll be happier, healthier, and wealthier.

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