misunderstanding risk

MISUNDERSTANDING RISK

Don M. Chance, PhD, CFAWilliam H. Wright, Jr. Endowed Chair for Financial Services

Louisiana State University

CFA South Africa Investment Conference 20099 September, 2009

Johannesburg, South Africa

Don M. Chance, Ph.D., CFAp. 2 of 42

A Most Difficult Decision

• What would you do if you found a suspicious growth inside a non-vital organ?• The doctor is unable to identify whether the

lump is malignant or not without surgery• The doctor gives you a choice:

• Remove the lump only, examine for the presence of cancer, and return for a second more extensive surgery if cancer is found

• Remove the entire organ, which you can live without, a more drastic surgery

9 September, 2009


Making Decisions Under Risk Not just in the financial world, but in life

in general We constantly make decisions under

risk Rarely are we ever presented certainty How we make those decisions tells us a

lot about the human appetite for risk and how we so often make risk mistakes

9 September, 2009


What is Risk?

9 September, 2009


Elements of the Definition of Risk? Exposure to an event Uncertain outcomes (Usually) undesirability of one or more

outcomes

9 September, 2009


Measuring Risk

Measures of riskProbability or oddsStandard deviationWorst case scenarioIn investing

○ Maximum drawdown○ Beta○ Value-at-Risk

9 September, 2009


Probability as a Measure of Risk

We do not understand it We misuse it All too often we assume the bell curve

and oftentimes we ignore the tails (the Black Swan effect)

9 September, 2009


A Simple (and somewhat silly) Example: The Monty Hall Problem

9 September, 2009

Door # 1 Door #2 Door #3

Behind these doors are three prizes: a car and two worthless prizes. A contestant chooses one door.


The Monty Hall Problem (cont.)

9 September, 2009

$0 Door #2 Door #3

Let’s say the contestant chooses Door # 3.

Monty then opens door # 1 to reveal one of the two worthless prizes and offers the contestant the opportunity to switch doors.

(the contestant’s choice)

Should the contestant switch? Most people say it doesn’t matter.


9 September, 2009

But it matters a lot!

You double your chance of winning by switching.

Odds of winning by not switching: 1-in-3

Odds of winning by switching: 2-in-3


A Tougher and More Serious Situation(described by Gerd Gigerenzer in the book Calculated Risks.)

One in every one-hundred 40-year old women has breast cancer

A mammogram detects 90% of all breast cancers and gives a false positive 9% of the time

A 40-year old women gets a positive mammogram. What is the probability she has breast cancer?

A sample of doctors believed it was very high (80-90%)

9 September, 2009


9 September, 2009

10,000 40-year old women

100 with BC 9,900 without BC

90 have + m/m

10 have – m/m

9,909 have – m/m

891 have + m/m

90

Actual Probability = 0.09290 + 891


Using Misleading Risk Information to Sell a Product

9 September, 2009

A pharmaceutical company advertises that a new cholesterol- lowering drug reduces heart attack risk by 22%.

(Also described in Calculated Risks)


9 September, 2009

1,000 people with high cholesterol

Receive new drug Receive placebo

32 die of heart attack

968 do not die of heart attack

959 do not die of heart attack

41 die of heart attack

1,000 people with high cholesterol

22% fewer heart attacks

(9/41 = 22%)


The Correct Interpretation

9 September, 2009

9 out of 1,000 people were helped by the drug.

In other words, of every 111 people who took the drug (1,000/9 = 111), one person was helped.

Would you take or recommend a drug in which 111 people have to take it for one person to benefit?


O. J. Simpson: What He Taught Us About Risk

9 September, 2009


9 September, 2009

The Defense Claim

100,000 battered women in U. S

40 murdered by their batterer

99,960 not murdered by their batterer

Odds that a battering led to a murder = 40/100,000 = 0.04% or 1-in-2,500


9 September, 2009

The True Picture

(not argued by the prosecution)

100,000 battered women in U. S

40 murdered by their batterer

5 murdered by someone else

Odds that a battered and murdered woman was killed by her batterer = 40/45 = 89%


The Weather

We are continuously confronted with risk information about the weatherWhat does x% probability of rain mean?What about hurricane prediction paths?Why is the weather more predictable than

most other uncertainties in life?

9 September, 2009


Political Polls

What does it mean to say that 51% favor candidate A and 49% favor candidate B?

What does a sample of 1,000 people out of a population of 100 million registered voters mean?

Why does the public opinion of politicians change so quickly?

9 September, 2009


Jury Duty

The American judicial system is terribly flawed in that it prohibits use of all information related to the risk

“Innocent until proven guilty”

9 September, 2009


Voting Voting is an amazingly low-risk situation, yet we

often act like it is a high-risk one Elected officials are typically elected by a fairly

uninformed populace They constantly clamor for an even more

uninformed populace to vote Which is better? Large turnout of uninformed

voters or small turnout of informed voters Ballot measures

9 September, 2009


Mental Health and Emotional Instability Identifying serial killers in advance Examples, true and false

Virginia Tech shootingImams on a planeSuspicious people

9 September, 2009


Predictors Predictors are notoriously pessimistic

AirlinesRestaurantsHospitalsWhy?

And what about the weather forecaster? What about economists?

Granville, Kaufman, Roubini Politicians running for office against an incumbent Predictors are almost useless, not because they

cannot predict but because they engage in self-protecting bias

9 September, 2009


Evaluating Predictors

We too often succumb to the small sample fallacy

It takes an incredibly large sample to adequately evaluate predictive ability

9 September, 2009


What does it Mean to Make a Mistake in Making a Decision Under Risk?

Given the choices A and B, you choose A

Assume that A works out poorly and it is apparent that B would have worked out better

Was that a mistake?MaybeMaybe not, but perhaps a lesson can be

learned (e.g., WMD in Iraq)

9 September, 2009


Common Risk Mistakes Confusing ex post with ex ante Inability to distinguish luck from skill or lack

of it Fearing risk less the further back bad

outcomes occur Overweighting highly improbable events and

underweighting highly probable events

9 September, 2009


Common Risk Mistakes(continued)

Trusting government for risk information Being irrational about risk Assuming that if a “bad” outcome occurs, it

would have been better to have made a different decision

Does the reward justify the risk? Is the cost of risk reduction worth it?

9 September, 2009


Common Risk Mistakes(continued)

Expecting some decision makers to be 100% correct

Paying too much attention to predictions

9 September, 2009


The Loneliness of the Decision Maker Sports Killing a product: the Coca-Cola case Decisions made by doctors Presidents and leaders of countries In understanding the decision maker, we

need to appreciate the Heisenberg Uncertainty Principal (of social science)Obama: “I was right about the war”McCain: “I was right about the surge”

Changing one’s mind (flip-flopping)

9 September, 2009


Risk Information – So Misleading

Violence in Iraq? Violence in the U. S. A new source of energy School violence Which is riskier?

a house with a gun or a house with a swimming pool

Lawn mowers or beds

9 September, 2009


How We (All too Often) Cope with Risk Litigation (mostly in the U. S.) Making someone else take the risk (as

in sports) Taking the safe route Relying too much on others, such as the

government, to make our decisions Overstating the amount of information

you have

9 September, 2009


Using Risk Ignorance to our Advantage A personal story from my teen years D-Day: 6 June, 1944

9 September, 2009


Viewing the Risk as Though it were Someone Else’s

Torture

9 September, 2009


Making a Tough Decision Under Risk: The Prisoner’s Dilemma

Two people are arrested and charged with the same crime

The suspects are put into different rooms and separately interrogated

Each is given an offerTestify against the other and receive

immunity (cooperate) If only one cooperates, that person is free and the

other is punished If both cooperate, each is given a lighter sentence If neither cooperates, both will be punished

9 September, 2009


The Prisoner’s Dilemma

9 September, 2009

Prisoner B

Cooperate Do not Cooperate

Prisoner A

Cooperate A: light punishmentB: light punishment

A: freedomB: severe punishment

Do not Cooperate A: severe punishmentB: freedom

A: punishmentB: punishment

Assuming that each prisoner has no idea what the other will do, each should independently decide to cooperate. Why?


How do We Manage Risk? Panic Forecast Decide on how much risk we want, how

much risk we have, the cost of changing the level of risk, and whether an adjustment is economically justified

9 September, 2009


Making Good Decisions under Risk Some times we have too many choices Get as much information as possible Decide which risks are worth taking and

which are not For risks not worth taking, evaluate the

cost of eliminating the risk and do so if supported by cost-benefit analysis

Be moderately pessimistic

9 September, 2009


What Should We do After the Fact? Do not assume that a decision that

turned out adversely was a bad risk management decision

A correct risk management decision was one that would be made again if the circumstances were identical

Do not evaluate the decisions of others without putting ourselves in their position

9 September, 2009


What Does This Mean for Investment Managers Use probability and risk quantification

but be sure you use it carefully Respect the past but don’t obsess over

it The financial media knows no more than

anyone else (and oftentimes a lot less) Investment decisions that look bad after

the fact can actually be good decisions

9 September, 2009


Risk is Good

Do you really want to know the future? What would a financial world be like if

there were no risk?

9 September, 2009


9 September, 2009

Thank you for having me here to speak.

If you have any questions later:

[email protected]

Feel free to email me for a copy of this presentation.

misunderstanding risk

Documents