Most of us have a flaw when reacting to risk: Threats like plane crashes, which are statistically insignificant but rare, grab our attention and scare us more than those that are deadly serious but common, like heart attacks and car accidents. The gap between the things we worry could happen and what's actually happening around us can be huge. Some estimate that as many as 20,000 Chinese coal miners die each year, nearly all without a word from the media. But if one died in a nuclear power accident, it would be global news for decades. If the U.S. news focused on the biggest threats we face, it'd write about almost nothing other than poor diet, lack of exercise and car accidents -- which are probably three of the least covered topics.
Coming to terms with the fact that nearly all of us are bad at assessing risk is vital to managing money. This is especially true because money is emotional and taboo, and many of us are financially illiterate and borderline innumerate.
Paul Slovic runs Decision Research in Oregon. He's spent his career studying how people judge risk. Slovic's research shows that people overestimate risk when a danger has a handful of qualities, including:
- Catastrophic potential: Lots of people affected at once, rather than in small numbers over time.
- Familiarity: A risk that isn't common knowledge.
- Understanding: A sense that something isn't well understood by experts.
- Personal control: A sense that danger is outside your control.
- Voluntariness: Something can do harm even when you don't voluntarily put yourself in danger.
- Children: Mention the word children and panic multiplies.
- Victim identity: As Joseph Stalin said: "One death is a tragedy; one million deaths is a statistic."
- Origin: Man-made risks are viewed as more dangerous than natural disasters.
You can imagine how these fit into finance.
People dread a big market crash because it affects everyone at once, but pay little attention to our abysmally low savings rate, which ruins individual people's financial lives slowly over time. We panicked over the flash crash in 2010, not because it was a big deal, but because it was a new, mysterious risk that we knew little about. And when you hear anecdotes about individuals fleeing the stock market in 2008, it sounds much more distressing than the reality of 97 percent of investors not fleeing the market in 2008.
In all of these cases, people focus on the wrong risks -- or overestimate risk and damage happening around them -- which leads to overreaction at the worst possible time. The best example of this comes from German professor Gerd Gigerenzer, who showed that the increase in car travel stemming from people's fear of air travel directly after 9/11 likely led to an increase in traffic fatalities measured in the thousands, and possibly more than the number of actual 9/11 victims. There's hindsight bias in that observation, but obsessing about a small risk while ignoring a much larger one is par for the course in human behavior. "People jump from the frying pan into the fire," Gigerenzer wrote.
In investing, high-profile risks that we talk about all the time, like whether stocks are going to fall next month or whether a company is going to miss quarterly earnings, aren't nearly as dangerous as the slow-burning risks we habitually ignore. Take these three:
Vanguard shows that if your investments earn a 6 percent annual return, a 1 percent management fee will reduce your account balance by half over 50 years. I can't imagine how many investors would shriek at a possible (and temporary) 50 percent market crash, but don't bat an eye at a fee that will guarantee them the same result with no chance of recovery.
2. Trading too much
Investors who do the least will likely do the best over time. For the huge majority of people, investing a set amount of money each month consistently over a long period of time will outperform any trading strategy they attempt. The evidence on this is overwhelming. It's so overwhelming that I think the single biggest risk you face as an investor is that you'll try to be a trader. It's the financial equivalent of drunk driving -- recklessness blinded by false confidence. "Benign neglect, bordering on sloth, remains the hallmark of our investment process," Warren Buffett once said. It probably should be yours, too.
3. Not saving enough
The personal savings rate is currently about 4 percent, which is half its long-term average. That statistic poses a way bigger risk to people's finances than the numbers that get thrown around showing how overvalued the stock market is. Most people spend too much time trying to become a better investor and not enough time trying to save more money. That's especially true if you're young. As the saying goes, "Save a little bit of money each month, and at the end of the year, you'll be surprised at how little you still have."
More financial misery has been caused by ignoring these three risks than by nearly all the irrelevant risks the investment media writes about all day long. Not realizing this is why most of us are bad at assessing risk.