Financial Intelligence - Counterintuitive Pattern 2: Overestimation and Underestimation of Risk

Counterintuitive Pattern 2: Overestimation and Underestimation of Risk




The second counterintuitive pattern relates to our ability to interpret risk. When assessing financial risk, we tend to slightly overestimate risks that are somewhat larger than normal and underestimate those that are smaller than average. This happens because our Stone Age brains lack the fine granularity needed for risk arousal. To clarify, let’s define two scales. The first is known as the objective risk level, which measures the actual risk of a specific event in the physical world, with 1 indicating no risk at all and 10 indicating extreme risk. The second is the subjective risk level, representing how our brain perceives the risk, with 1 meaning we don’t see it as risky at all, and 10 meaning we see it as a life-or-death threat. Ideally, these scales should align. For example, an objectively level 3 risky event should be perceived as level 3 subjectively. However, in the financial realm—especially among those without systematic finance training—we tend to view all objective risks from levels 1 to 5 as subjective risks at levels 1 or 2. Similarly, we regard all objective risks from levels 6 to 10 as subjective risks at levels 9 or 10. In essence, our perception of risk is quite binary—either “everything is fine” or “everything is doomed.”

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There is a physiological reason for this. Evolutionarily, human brains developed complex and powerful structures to handle immediate threats. For instance, when confronted with a threat like a tiger approaching, our amygdala fires a lightning-fast response within a fraction of a second, sending chemical-electrical signals to multiple parts of the brain, including the prefrontal cortex (the executive function centre), the limbic system (the emotion system), and the hypothalamus (the structure controlling multiple organs via hormones). The prefrontal cortex alerts you about the tiger, focusing solely on survival. The limbic system searches your long-term memory, loading all past encounters with tigers and sharing knowledge from others on how to handle such crises, to your conscious mind. The aim is to craft the best strategy to fight or flee. The hypothalamus, again in a fraction of a second, releases chemicals to the pituitary gland (also in the brain) and the adrenal gland (on top of the kidney), triggering further waves of physiological response. All these reactions occur within a few seconds, as we typically don’t have the luxury of time to slowly evaluate situations and gather information when facing risks like a tiger. In a natural environment full of life-or-death risks, our brain has evolved to categorise any potential high-risk event as extremely high. Using this two-scale system, we tend to rate any objective 5 to 10 level risk as level 10. This way, we’re less likely to miss reactions to truly dangerous events. A strange sound behind the tree? No worries, mark it as a level 10 risk since it could be a tiger. If not a tiger, all it costs us is sweaty palms, pounding hearts, and extra energy. A curved shape on the ground? No worries, mark it as a level 10 risk since it could be a poisonous snake.

When we bring this mindset of ‘if it is risky, let’s mark it as a level 10 risk’ into the finance world, it isn’t ideal. As outlined at the start of this chapter, finance’s abstraction and generalisation are quite new to the brain. When we face a risk in an abstract context, the part of our brain that deals with tigers can be triggered. Stock market drops by 2%? No worries. Drops 10%? Still fine. Drops 20%? Tiger! Level 10 risk! Amygdala activation! Adrenaline kicks in! Panic selling all stocks! This occurs daily, where people see a big market dip and panic sell, missing the chance to recover their losses. In a highly volatile market, a 20% drop might be a level 5 or level 6 objective risk. But, due to the strong reaction from the ancient parts of our brain, we perceive it as a level 10 subjective risk, leading to less optimal decisions.

Conversely, our brains tend to overlook mid to low-level risks because reacting to them uses energy, which is precious in the long history of evolution. We couldn’t afford to respond to every potential risk, so we chose to ignore the smaller ones. Is it getting a bit cold outside, and hypothermia might occur? No worries, we’ll find shelter when it really gets cold. A few bees around? No need to run, as they might not be harmful and might not sting. We simply couldn’t afford to act on these small-scale risks, so we treat them as level 1 subjective risks.

When we apply the mindset of “if it’s not that bad, then mark it as level 1” to the financial world, we tend to overlook risks. Many financial risks fall into the level 3 to level 5 range, meaning they are not immediate threats but still require attention. For instance, in personal finance, it’s advised that households have emergency funds to cover 6 to 12 months of expenditures. If a large purchase causes the family’s emergency fund to dip below 6 months, even though it doesn’t pose an immediate threat to daily life, action should be taken to rebalance liquidity, sell assets, or cut back on spending to refill the emergency fund. However, because we often ignore low risks, many individuals delay taking action, which can reduce the family’s resilience to financial risks like losing a source of income. Another example of neglecting small to medium risks is overlooking family asset distribution. If a family’s income mainly comes from highly volatile sources such as cryptocurrency and stock dividends, it can create an illusion of financial stability. When the family’s liquidity portfolio becomes heavily weighted with volatile assets, steps should be taken to ensure there’s enough cash or cash equivalents.

How can we minimise the impact of the counterintuitive nature of risk estimation? The well-known saying captures it perfectly: In finance, things are never as good as they seem, nor as bad as they feel. The truth usually lies somewhere in between. Since our minds tend to overestimate risks above the average, we should remind ourselves, “This is not as bad as it feels,” when facing risks that seem daunting. For instance, losing a stable income can feel overwhelming. However, let’s take a step back and evaluate the family’s savings, the individual’s employability, and the job market. It might just be a temporary income pause rather than a serious financial threat. On the other hand, we can increase the risk level when dealing with small to medium risks, as our minds tend to overlook them. If a house insurer announces a major change to the business, such as being sold to another firm, it’s time to review the house insurance renewal policy, as it may differ significantly from the original. Another example is not having a will; it might be acceptable if the family assets are simple, but it could pose a real risk if misfortune occurs and children cannot smoothly cover living expenses from the legacy.