We tend to base our assessment of risk on emotions (how we feel about it), and then rationalize (or try to) that we have done so using objective data.
Our Reactions
We overreact to risks we can’t control (like the fear of natural disasters) and under react to risks we can (like one’s health, or how we drive a car). We particularly overreact to risks that are uncontrollable, have catastrophic or even fatal consequences and involve “one group taking a risk and a separate group reaping the benefits.
Probability Estimation
We overestimate small probabilities and underestimate large ones. It’s we purchase lottery tickets and why we continue to eat more and more poorly than we should.
Another perception factor is “ease of imagination.” We can easily imagine the horror of being attacked by a shark while at the beach. Consequently, we have a heightened fear of such an occurrence, even though the rate of shark attacks is only one in many million beach goers.
Familiarity Distorts Risk Perception
We are tolerant of risks that are familiar, frequently encountered or part of a well-understood system, like the stock market. This makes it more difficult for investors to take this risk seriously. We perceive unfamiliar risks, like school shooters or terrorism, with a heightened sense of fear and anxiety. Unfortunately the probability data doesn’t support this conclusion.
Questions To Ask Yourself
Are you concerned about stock market risk? If so, why? If not, why not?
Are you comfortable with the plan you have in place to deal with this risk? If so, why? If not, why not?
What kind of risk keeps you up at night?
Now think about:
how you might be under reacting or over reacting…
how well you are informed about the true probabilities of these events happening …
how your sense of each risk is modified by your sense of familiarity with each event…