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About “Risk”: Probability and Impact
May 2020

May 29, 2020 | Business Owners | Cash Flow | Families

Which animal poses more risk to humans, deer or sharks?

If measured by number of casualties caused, deer are orders of magnitude riskier than sharks (in the US, sharks kill, on average, 1 person every 2 years, whereas collisions with deer cause 400 deaths in the same time period).

We often talk about “risk” imprecisely. We sometimes mean “discomfort,” we sometimes mean “fear of loss,” we sometimes mean “threat to life.” One framework for understanding risk is to consider the probability and the impact of an event:

High probability, low impact risks (a brief power outage, for example) are generally not going to change the long-run outcome – though there may be some expected inconvenience.

High probability, high impact risks (the need to replace a vehicle) can have material consequences for an outcome – and given the likelihood of occurrence, leave plenty of room for planning ahead.

Low probability, low impact risks (getting stranded while travelling) can make for great stories, after the hassles are overcome, but don’t tend to derail long-term plans.

Low probability, high impact risks (getting killed by a shark or deer) can completely change the course of a life’s plan, though judicious planning (and sometimes insurance) can reduce the impact of unintended outcomes.

It is often easy to imagine the impact of an event. It is somewhat harder to comprehend the probability. And sometimes our understanding of impact can influence beliefs about probability.

Cognitive biases can distort our thinking of probability. One such trick of the mind is the “availability bias” which leads us to consider something more likely if we’re able to imagine it happening (this is why sharks can seem like a greater threat than deer). The way information is framed can also change our perceptions of risk – for example a “10% chance of failure” feels riskier than a “90% chance of success” (and reproducible studies have shown this to be true).

As you hear about risks, whether related to contracting an illness or investment markets or shark attacks, we encourage you to take a step back and think about how likely something is to occur (based on the best data available) and how big of an impact it would have if it were to occur.

 

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