By Terry Burnham
Nearly all managers have a risk model in place. Yet standard risk analysis is almost always wrong. Recent behavioral and neurological studies suggest that our troubles with risk are built firmly into our brains. To successfully navigate this risky climate, we need to understand and tame an internal enemy that we cannot escape.
Traditional economics argues that all humans have a built-in, flawless ability to handle risky situations. In this old-school view, our brains rationally evaluate various outcomes, good and bad. The overall judgment of a risky situation gets boiled down to a single number based on the probabilities of the outcomes and our feelings toward them.
But the behavioral school of economics, largely through experimental work, has documented a long and growing list of anomalies, or divergences between the way people actually make decisions and economic theories about those choices. These anomalies provide the fuel that is driving the behavioral revolution.
When it comes to risk, two anomalies of traditional economics stand out. First, people have an extreme, irrational hatred of losses. This loss aversion is so powerful that investors with mildly negative returns will take risky and ill-advised positions to get back to even. Second, a less well-explored flaw is our inability to deal with low probability events. The estimate of the chances for a market meltdown, for example, goes up dramatically when prices decline. This makes us want to buy downside protection at precisely the time it is most expensive and least needed. People tend to use the recent past to predict future risk, but typically this results in low risk predictions when the risk is actually quite high. People are most comfortable when they should be most scared.
Recent research on risk has moved inside the brain. There we find that the foundational, neurological circuits produce a flawed approach to risk. Our brains are built to make it hard to manage our finances well.
Our brain-reward circuits are powerfully influenced by expectations. We find it difficult to make rational decisions about risk when our evaluations are changed by an external event that alters expectations. When markets are much cheaper than they were a few weeks before, the decline in price, from a rational or traditional economics perspective, would make them more attractive. However, the basic brain machinery that evaluates these investments has been altered by recent events. We cannot see clearly because our brain does not allow us to do so.
If the enemy lives in our own heads, what are we to do?
First, we must realize that our brain is not one cohesive entity. Parts of our brain do perform much as the rational model suggests, coolly calculating percentages and seeking the best choice. Much of this rational portion lives in the pre-frontal cortex, a part of the brain that lies over the eyes and stretches back toward the ears.
Second, because the errors in dealing with risk lie inside an inflexible neural architecture, we cannot override them. At a fundamental level, to overcome our irrationality, we must learn and embrace this part of ourselves.
Third, we need to design systems and practices to ensure that our most important decisions are made rationally, with our pre-frontal cortex, and not emotionally. An important principle is to use rules that cannot be overridden at emotional moments. For example, a rule to rebalance asset allocation on a regular basis is useful because it helps constrain our natural tendency to underestimate risk after the market rises.
Better risk management systems can be developed by pre-empting irrational decisions in heated moments and planning ahead accordingly. For example, risk protection in the form of derivatives should be purchased in advance, not in the middle of a crisis. When stocks plunge in a sell-off, the cost of buying protection is substantially greater than before. By way of analogy, who would wait until getting into an auto accident before buying insurance?
The barrier to effective risk management lives inside the back of our skulls. To improve, we must understand and embrace the enemy within.
Terry Burnham, senior vice president and director of economics, Acadian Asset Management Inc., Boston, specializes in studying the relationship between human behavior and the economy and financial markets. A former economics professor at Harvard University's business school, Mr. Burnham is the author of "Mean Markets and Lizard Brains" (published in 2005 by John Wiley & Sons Inc.), which examines how the brain drives individuals to make unwise financial decisions.
