Assessing risk for decision making

Assessing risk for decision making
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First Published: Mon, Aug 18 2008. 12 18 AM IST
Bombs exploding in marketplaces, terrorists hijacking planes, tainted meat that can eat your flesh and dangerous viruses that kill in seconds. The world seems a dangerous place today and it is a wonder that many of us are even willing to step out of our houses. Better to go spend a relaxing afternoon in a swimming pool instead.
But the risk of dying in a swimming pool is many times the risk of death by bombs, hijacked planes, bad meat and killer viruses—combined. Still, as a society we spend a great deal more time and money trying to minimize small risks than we do avoiding larger risks. Psychologists have spent considerable effort in understanding our inability to accurately gauge risks. From a purely economic perspective, the true “risk” of any outcome is simply the probability of an outcome multiplied by the value of that outcome. The risk of dying in a terrorist attack is simply the probability of a terrorist attack times the value of your life. But since the likelihood of being in a fatal terrorist attack is so infinitesimally small, why do we worry so much more about it than keeling over with a heart attack, which is so much more likely?
First, we are very poor at judging probabilities. We tend to focus on things that are memorable and vivid and give it higher probabilities. When asked to estimate whether there are more words in the English language that begin with the letter “r” or that have “r” as the third letter, people generally try to recall a series of words that would fit these conditions in order to make the estimation. As a result, most people estimate that there are more words beginning with “r”. As you may have guessed by now, there are many more words with “r” as the third letter than those beginning with “r”.
The media plays into this bias by hyping certain dangers and making them more salient. So, people feel the risk of dying from a bomb blast or from cancer to be a lot higher than it really is and underestimate the risk of dying from drowning in a pool or from asthma. This emotional response to probabilities also influences our assessment of objective probabilities. Imagine being offered a lottery ticket for Rs10. There are only 100 tickets available and 99 have been sold to 99 other people. The prize in the lottery is Rs1,500. Simple probability would suggest that this is a very good deal. The expected value (likelihood of winning times the value of the win) is Rs15, but you’re only being asked to pay Rs10. This looks like a reasonable deal and most people take such an offer. Now suppose I told you that a single person had bought the other 99 tickets. Do you still want to pay Rs10 for the 100th ticket? Interestingly, people are less likely to accept the second offer than the first. Emotionally, the thought that a single person has 99 of the 100 tickets somehow makes it seem almost a foregone conclusion that that person will win the lottery. The Rs10 ticket deal just doesn’t seem as good even though the odds of winning are exactly the same whether the 99 other tickets are held by one person or by 99.
Second, people respond more strongly to infrequent sources of risk than ongoing sources. That is why you are less likely to get funding from the government for reducing traffic deaths than for reducing the risk of terrorist attacks even though traffic accidents claim more lives than does terrorism. Somehow, it seems more outrageous to allow 10 deaths in one day from an avoidable terrorist attack than to avoid 100 deaths over a month from avoidable traffic accidents.
Third, voluntary actions that lead to risky outcomes are not as fear-arousing as the actions of others that lead to risky outcomes. Somehow, deciding to work in a nuclear power plant is seen as less risky and outrageous to a person than finding that a new nuclear plant is going to be built in your neighbourhood. You underestimate the risk of riding in a car when you are driving and overestimate the risk of flying in an aerplane that is being piloted by another person. As a result, managers are more likely to engage in costly risky behaviour and also likely to overspend to protect against smaller, uncontrollable risks.
Biased risk perception has important implications for managerial decision making. Managers are constantly evaluating the likelihood of various outcomes and the costs of avoiding bad outcomes. They need to make sure that their responses are driven by appropriate risk assessment, and not fear. Fear is an emotional response to perceived risk. If you are making significant decisions based on the fear of an outcome, you are likely making poor decisions. While it is impossible for people to completely keep their emotions aside and assess risk accurately, awareness can help you to more consciously consider the actual risk in many decisions. While fear is an emotion that may negatively affect decisions, risk assessment and effective risk management are essential components of good managerial decision making.
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Praveen Aggarwal is an associate professor of marketing at the Labovitz School of Business & Economics at the University of Minnesota Duluth and Rajiv Vaidyanathan is a professor of marketing and director of MBA programmes at the University of Minnesota Duluth.
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First Published: Mon, Aug 18 2008. 12 18 AM IST