Jay L. Zagorsky :
Risk is everywhere and associated with everything. For example, the Centers for Disease Control and Prevention a decade ago estimated over 20 million people a year ended up in emergency rooms because of bathroom injuries.
While this figure is shockingly high, it probably won’t prevent you from using the toilet or washing your hands. And in general, hiding under the bed to avoid risky decisions is not a realistic option for living life.
In part, that’s because we’re all risk analysts, continually weighing the costs and benefits of every decision we make. The problem is, most of us aren’t actually that good at it. As an economist, I thought it would be interesting to explore how we weigh risk in our daily lives – and how we might be able to do it more accurately.
We spend a great deal of time making decisions with at least a little risk involved. Some of them are relatively ho-hum, such as what to wear to work with a minor risk of a colleague wearing the same outfit, while others are potentially fatal, such as whether to sprint across the street when the sign says “don’t walk.” Part of evaluating each risky situation is knowing how likely it is that something will happen. It is also just as important to know the cost if something goes wrong or the payoff if something goes well.
Scholars call the odds of something happening multiplied by the cost or payoff the “expected value” of a situation. The problem is people aren’t very good at estimating the two variables required to get an expected value.
Part of expected value is understanding the probability or odds of a situation.
Probability is the chance something will happen and is simply a number from zero percent – an impossibility – to 100 per cent – a sure thing. No matter how many times a coach screams at a player to give 110 per cent, this figure is outside the realm of possibility.
Expected value requires estimating the odds that something might occur. However, when behavioral science pioneers Daniel Kahneman and Amos Tversky studied how humans estimate probabilities they found people have poor judgment calculating actual probabilities. In general, humans overstate the likelihood of rare events occurring, underestimate the chance common events will happen, and overvalue certainty.
For example, many people are terrified about flying on planes because of the possibility of a crash. However, the actual chance of someone dying in a commercial airline crash is very close to zero.
On the other hand, the flu is very common. Every year millions of people get the flu and thousands even die from it. Nevertheless, many people do not get a flu shot – almost 60 percent of adults and 40 percent of children in recent years – because they don’t think they will get the flu.
The cost or the payoff is the other part of expected value. One problem is the cost or payoff isn’t always as obvious as in the case of a speeding ticket, and sometimes assigning a dollar value can be complicated.
Kahneman and Tversky also found that people feel more pain from a loss than pleasure from a similar-sized dollar gain. Being forced to pay a $500 fine for running a red light makes people suffer more mental anguish than the happiness they would get from winning $500 for being randomly rewarded for stopping at a traffic light.
The particular pain from having money taken away is called loss aversion. Because people loathe or hate losses they often buy insurance. Having insurance means giving up a small certain payment today to ensure a large uncertain payment won’t be required in the future. Risk is an inherent part of our lives. There is almost nothing we can do to make the world a more certain place. We all have to cross streets, and many of us have to fly in planes or drive cars.
However, when faced with a risky choice, you need to think not only about the odds but also the cost or payoff. It is less important whether you use the simpler expected value model or take into account our human quirks and use prospect theory. What really matters for making better choices is to understand that risk is more than just the chance something will occur.
(Jay L. Zagorsky is Economist and Research Scientist, The Ohio State University. Courtesy: The Conversation).
Risk is everywhere and associated with everything. For example, the Centers for Disease Control and Prevention a decade ago estimated over 20 million people a year ended up in emergency rooms because of bathroom injuries.
While this figure is shockingly high, it probably won’t prevent you from using the toilet or washing your hands. And in general, hiding under the bed to avoid risky decisions is not a realistic option for living life.
In part, that’s because we’re all risk analysts, continually weighing the costs and benefits of every decision we make. The problem is, most of us aren’t actually that good at it. As an economist, I thought it would be interesting to explore how we weigh risk in our daily lives – and how we might be able to do it more accurately.
We spend a great deal of time making decisions with at least a little risk involved. Some of them are relatively ho-hum, such as what to wear to work with a minor risk of a colleague wearing the same outfit, while others are potentially fatal, such as whether to sprint across the street when the sign says “don’t walk.” Part of evaluating each risky situation is knowing how likely it is that something will happen. It is also just as important to know the cost if something goes wrong or the payoff if something goes well.
Scholars call the odds of something happening multiplied by the cost or payoff the “expected value” of a situation. The problem is people aren’t very good at estimating the two variables required to get an expected value.
Part of expected value is understanding the probability or odds of a situation.
Probability is the chance something will happen and is simply a number from zero percent – an impossibility – to 100 per cent – a sure thing. No matter how many times a coach screams at a player to give 110 per cent, this figure is outside the realm of possibility.
Expected value requires estimating the odds that something might occur. However, when behavioral science pioneers Daniel Kahneman and Amos Tversky studied how humans estimate probabilities they found people have poor judgment calculating actual probabilities. In general, humans overstate the likelihood of rare events occurring, underestimate the chance common events will happen, and overvalue certainty.
For example, many people are terrified about flying on planes because of the possibility of a crash. However, the actual chance of someone dying in a commercial airline crash is very close to zero.
On the other hand, the flu is very common. Every year millions of people get the flu and thousands even die from it. Nevertheless, many people do not get a flu shot – almost 60 percent of adults and 40 percent of children in recent years – because they don’t think they will get the flu.
The cost or the payoff is the other part of expected value. One problem is the cost or payoff isn’t always as obvious as in the case of a speeding ticket, and sometimes assigning a dollar value can be complicated.
Kahneman and Tversky also found that people feel more pain from a loss than pleasure from a similar-sized dollar gain. Being forced to pay a $500 fine for running a red light makes people suffer more mental anguish than the happiness they would get from winning $500 for being randomly rewarded for stopping at a traffic light.
The particular pain from having money taken away is called loss aversion. Because people loathe or hate losses they often buy insurance. Having insurance means giving up a small certain payment today to ensure a large uncertain payment won’t be required in the future. Risk is an inherent part of our lives. There is almost nothing we can do to make the world a more certain place. We all have to cross streets, and many of us have to fly in planes or drive cars.
However, when faced with a risky choice, you need to think not only about the odds but also the cost or payoff. It is less important whether you use the simpler expected value model or take into account our human quirks and use prospect theory. What really matters for making better choices is to understand that risk is more than just the chance something will occur.
(Jay L. Zagorsky is Economist and Research Scientist, The Ohio State University. Courtesy: The Conversation).
