my thoughts...: Risk Intelligence

We've been doing a fair amount of work on developing algorithms for the equity markets and hence a subject that I happily discuss a lot. One of the things that stood out to me was that many of the people I discuss the same with, and even those in the financial fields are unable to appreciate "Risk" and its implication to the possible end results.

It has also seemed to me that many of the financial crisis were triggered by this lack of appreciation. I'm also learning Poker, one of the items on my bucket list. And I found that the understanding of Risk in a game of chance was much higher than in what's supposedly, "Investment".

Here are a few videos that not only gave me a much better insight on a new term I learnt "Risk Intelligence", but also showed why I should not have been surprised that most people don't understand Risk.

What Can We Learn From Expert Gamblers?
Dylan Evans at TEDxWestlake

And this excellent article in Forbes.

How Risk-Intelligent Are You?

Try this very simple test. If I offered you the choice between the following two bets, which would you take?

Bet 1; toss a coin. Heads, you win $75. Tails, you lose $50.

Bet 2: roll a dice. A six, you win $750. A 1,2,3,4 or 5, you lose $100.

Good or bad bet? You decide.

So which would you choose? Or would you prefer not to take either?

If you chose the coin toss, or declined to play at all, then you are not risk-intelligent at all.

If you chose the dice roll with some internal conflict, or after making a calculation, you are risk-intelligent.

If you chose the dice roll instantly, intuitively with no internal conflict or conscious calculation, then you are very risk-intelligent.

Let me explain the logic. And then, I will explain what this has to do with business.

These three possibilities have been set up so that their mathematical attractiveness is inversely proportional to their psychological attractiveness. Bet 1 has an expected value of $12.50; put another way, if you played it repeatedly you would on average win $12.50. Bet 2 has an expected value of $41.67 - more than three times as attractive. Not playing, of course, has an expected value of zero.

That's the mathematics, but the psychology is quite a different matter. When making these sorts of choices, our default mode is not to calculate the gains and losses mathematically, but to weigh them psychologically. The coin toss is unappealing psychologically because the pain of losing $100 weighs more than the pleasure of winning $150 (in studies, experimenters have found they needed to offer a gain of $250 to get even a majority of people to accept the bet). The dice roll is even less attractive psychologically - the potential loss is larger, and more likely.

So, if you declined to play or chose the coin toss, you allowed your psychological bias to lead you away from the most profitable option.

If you were like most people who chose the dice roll, you had to overcome a conflict between basic psychology, which wanted you to avoid loss, and intelligent risk assessment. Choosing the mathematically superior option probably felt uncomfortable but once you had calculated the odds you overcame that discomfort. If this is you, then you are risk-intelligent.

Finally, you may be one of the small majority who chose the superior option with no psychological conflict and no need for a calculation. If this is you, then you are extremely risk-intelligent.

What does this have to do with business? Everything. Your work offers you a constant stream of bets, although they are usually called "investment opportunities." They may be big like developing a new product, or medium-sized like trying to win a significant new customer, or as small as spending a couple of hours reorganising the way you do some particular thing in order to save 10 minutes day. They all offer different levels of risk and return. The danger is that our natural loss aversion either prevents us from taking any of these opportunities because of the risk of loss, or limits our attention to those which offer reasonable chances of success, like the coin toss. The problem is that there may be better opportunities out there, but they look more like a dice roll and so we avoid them.

What would your business be if you became more risk-intelligent?

https://www.forbes.com/sites/alastairdryburgh/2018/01/30/how-risk-intelligent-are-you/#58090e826622

And here's my favorite on how to Manage Risk.
Three Simple, Fun and Effective Tools to Help Manage Risk
Will Gadd