risk analysis (and why you stink at it)!

The Psychology of RiskThe Psychology of RiskDaniel Crosby, Ph.D. www.doctordanielcrosby.comDaniel@doctordanielcrosby.com(256) 683-5551

You’re terrible at gauging You’re terrible at gauging risk!risk!

You’re full of yourself.You’re moody.You don’t have all the facts.You’re a follower. You’re scared of being a loser.You’re a control freak.

You’re full of yourselfYou’re full of yourselfOptimism bias - we

tend to believe that we’ll do better than most others engaged in the same activity

BYU therapist studyCook College - 15%

more on positive, 20% less on negative

“Personal Fable”

You’re moodyYou’re moodyAffect heuristic-good

feelings lead to lower risk perception

We cannot perceive risk independent of mood

=examine fewer variables, chosen quickly,disregard contradictory info

=“analysis paralysis”, long decision times, inaction

You don’t have all the factsYou don’t have all the factsHawaii sharksAvailability heuristic-

judgments of the likelihood of future events are made by assessing available info

Botulism vs. DiabetesMore words with “K” as

the first or third letter?

Rank from most to least likelyDying in the bath or shower.Victim of a shark attack.Having a stroke.Getting canonized. Attacked by mountain lion. Serious shaving injury.Getting away with murder.Death by flammable nightwear.

Survey says…Murder -1 in 2Stroke - 1 in 6Fatal bath - 1 in 2,232Shaving injury - 1 in 6,585Saint - 1 in 20 millionNightwear - 1 in 30 millionMountain Lion - 1 in 32 millionShark attack - 1 in 300 million

The Asch Experiment Bob the Chess Player and

“Risky Shift” Later referred to as “Group

Polarization” In groups, people become

risky with small stakes and more conservative with large stakes

You’re a follower

600 People With Deadly Virus A.) If adopted,

200 people will be saved for certain.

B.) If adopted, there is a 1/3 chance that 600 people will be saved and a 2/3 chance that none will be saved.

C.) If adopted, 400 people will die for certain.

D.) If adopted, there is a 1/3 chance that no people will die and a 2/3 chance that 600 will die.

You’re scared of being a loserPeople are twice as unhappy about

a loss as they are pleased by a gain.

A over B; 3 to 1.D over C; 4 to 1.People prefer the sure option when

the problem is faced as a gain, but prefer the riskier option when the problem is framed as a loss.

You’re a control freakYou’re a control freakPeople often treat

chance events as if they were skills and therefore under their control

50 lotto tickets - $8.67 for those who chose, $1.96 for no choice

Research shows that people overestimate their control on their organization’s stock

So what do I do?So what do I do?Determine personal risk profileBalance optimism with other

viewpoints; realize it can happen to youDon’t shop when you’re “hungry”Gather data from a variety of sourcesWatch tendency for “groupthink”Don’t let fear of loss stop you or make

risky investments to chase lossesUnderstand what is controllable

Perception of VolatilityAnnualized

Avg.=10%US Market SD=20%Last three years

SD=7%Consider volatility of

recent market relative to availability heuristic

August 9, 2007 - DJID drops 387 points, would have been 70 points in early 90’s

Reward for riskTradeoffs-bulletproof

vests/airplanesStocks have

returned over 10% annually on average over the last 80 years

Higher returns are your rewards for risk tolerance

Volatility allows for bargains

Risk for the risk-averseRisk and volatility decline over time“Black Monday”, October 19, 1987

- Dow fell 23% in a day, but was up 2% for the year

Market loses money in only 1of every 8 five year periods

Over 15 year periods, stocks scored positive returns every time

Psychology and investing“You have to work to make money in

the stock market. To a small degree, the work entails picking good companies or good mutual funds. But most of the work is enduring the anxiety and fear of owning something that could be worth a good deal less tomorrow than it is today. The challenge is to hang on to good firms through thick and thin.”

-James Glassman, Kiplinger