Here are a couple of conundrums for you:
#1: Would you rather…
… have the certainty of $100?
… take the gamble of a 1% chance of $0, 89% chance of $100, 10% chance of $500?
#2: Would you rather…
… take the gamble of 89% chance of $0 and 11% chance of $100?
… take the gamble of 90% chance of $0 and 10% chance of $500?
This is a paradox of risk, as described in Aswath Damodaran’s Strategic Risk Taking: A Framework for Risk Management. It’s such a great book!
In Conundrum #1, most people would choose the first choice (certainty of $100). And in theory, that means they should pick the first choice in Conundrum #2 as well. However, most people don’t. They switch and most people prefer the second choice in Conundrum #2.
So people like the risk-averse certainty in Conundrum #1 but they become risk-seekers in Conundrum #2. That is fascinating to me!
People are mixed up when it comes to risk. They don’t always act consistently (and their inconsistency doesn’t always follow a perceptible logic). Here are a couple of examples that I encounter frequently:
- Investors who claim to be risk-averse and they prefer to put their money into investments they perceive to be safer (such as bonds, mutual funds, and blue chip stocks) but then they put a bunch of money into the shakiest penny stock that they overheard their neighbor talking about — without doing any due diligence on the stock.
- Some people are so scared of taking a risk in the market that they keep all their money in their bank account, which is a guaranteed way to lose at least 3% per year (in inflation) plus maybe some additional money in fees.
- Aspiring real estate investors who claim that they are struggling to put together real estate deals because they don’t have the money or the time… and yet spend tens of thousands of dollars on training with guru real estate investors.
- Or consider this example that we’ve all seen: People who barely have a dollar to buy food or clothes will spend their money on lottery tickets.
I’m just listing a few interesting paradoxes here. I do realize that these are more complex than the simple summation I’ve just listed; there is a lot going on in the minds of the people who are facing these risk conundrums. But I’m listing them here because they illustrate my observation of one of Damodaran’s points — that we approach different risks in different ways and we aren’t always consistent in how we act.
Damodaran lists a few reasons for this. Without extensively quoting him, a few of the reasons include our perception of the risks of each choice, as well as the comparison of value (or “utility”) between the choices we have (that is why people tend to prefer the second, riskier choice in Conundrum #2 from the beginning of this blog post).
I’m quite interested in this inconsistency. I’m also fascinated by how prevalent it is. I think it’s something that impacts everyone. Take, for example, Merlin Mann — a guy who does a lot of interesting stuff online. Listen to a talk he gives in New Zealand about being scared but doing something anyway. (Note: He takes a couple of minutes to get going but once he does, it is quite moving. Also, some of the language is obviously NSFW).
Without using the same “risk” language as Damodaran and I, Merlin Mann is telling people that it’s okay to take risks because everyone is scared but that shouldn’t stop us from doing it anyway. And this ties in with what I’ve written lately about killing comfort and embracing change and calm seas do not make skillful sailors and reveling in chaos.