Assessment of risk

Freakonomics author Steven Levitt says that humans are generally bad at judging risk. I agree, and I think it's a fascinating topic. It's also much more important than we give it credit for - many decisions we make are on the basis of evaluating various risks.

A friend asked my advice about getting "audit insurance" offered by his accountant. The policy costs $750 and covers accounting fees of up to $20,000. The problem is most people aren't in a position to evaluate the value of the policy. But if we make a couple of assumptions we can make an educated guess. If 1% of Australian companies are audited by the Tax Office every year (my guess is that is high), and the average cost of accounting fees when you get audited is $10,000, then the value of the policy is $100. In other words you have a 1 in a 100 chance of getting a $10k payout, so on average you get $100 back for your $750. The rest of the money goes to the insurance company underwriting the policy, and the mark-up that the accountant puts on it.

So the only reason to get this insurance is if you think the cost of the audit would put you out of business (in which case you are in serious trouble anyway).

In Thinking Fast and Slow (a brilliant book on how we think) Daniel Kahneman talks about how we think about unlikely events. He says:

  • People overestimate the probabilities of unlikely event
  • People overweight unlikely events in their decisions

And this irrational behaviour around unlikely events can be expensive, and some companies will take advantage of this.

The extended warranty is a good example of this. The extended warranty is always massively overpriced. And a consumer has no way of evaluating the probability of the mobile phone breaking down in the second year, so will pay $50 for a extended warranty that only has a $5 value.

And as Thaler and Sunstein point out in their book Nudge, this is a problem that the free market cannot resolve "in part because it takes the salesperson a while to persuade someone to pay twenty dollars for two dollars' worth of insurance, and in part because it is difficult for third parties to enter this market efficiently."

So what should we do about this?

The first thing is to simply recognise that we are bad at judging risk, and determining the value of avoiding the risk.

The second is to attempt to make these decisions rationally rather than emotionally. Lots of decisions are better made emotionally, but assessing risk and determining how to mitigate it isn't one of them.

And thirdly, never buy the extended warranty!

Wow - long one this week. Love to hear your thoughts - how are you going at evaluating risk? You can leave your thoughts below.