Risk is a complicated topic.
It’s hard to define. It’s impossible to eliminate. And our perception of risk can often have unintended consequences.
When things feel safer, we can let our guards down, which actually increases risk in many activities.
Last year roads were far less congested because people weren’t traveling as much due to the pandemic. Yet U.S. traffic deaths were at a 13 year high, up 7% from the year before.
How could this be?
Roads were less congested so people took more risks by speeding, failing to wear their seatbelt or driving under the influence. The roads were “safer” but people took that safety to mean they could take even more risk.
A similar dynamic played out following the 9/11 attacks. Miles flown on airplanes dropped somewhere around 20% in the months after the attacks as people were afraid to fly. That meant more people on the roads and more accidents.
Researchers determined nearly 1,600 people died in car accidents above and beyond the averages because so many more people were on the roads.
It also helps to remember everyone’s appetite for risk is different.
The old George Carlin bit about how we view other drivers on the road is the perfect description of how your personal vantage point colors how you view the riskiness of other people’s behavior:
The same person can be an idiot or a maniac depending on the circumstances.
In The Right Stuff, Tom Wolfe documented the lead-up to landing a man on the moon in the 1960s.
Many of the early rocket prototypes were tested by Navy pilots. This technology was still new, unproven and highly dangerous. Yet more Navy pilots died in car crashes than air crashes during this time since they were more careful when flying and more reckless when driving.
It’s not just risk itself that matters but your perception of risk and how that changes depending on the circumstances.
We had this very interesting and spirited discussion where Daniel went into a big company and he said, “Here’s this thing on base rates and most new products fail, and you guys have to be aware of that.” The head guy from the company said, professor with all due respect, if we actually believed everything you just said, we would never launch a new product and then we would never have these five new awesome products that we’ve launched. There is this interesting balance just in general, between optimism, and this idea that we all have little psychological bubbles around our heads, and we think we’re a little bit better than we actually are. What’s good about that from a motivation point of view, it gets you out of bed in the morning.
Most businesses and products do fail but if every entrepreneur used failure as their base case there would be no such thing as Google or Tesla or McDonald’s or Apple the skip intro button for Netflix or any of the wonderful ideas that have been turned into businesses and products over the years.
The nature of risk is that you just don’t know until you actually try.
Risk can also be context-dependent and depends on your time horizon.
Stocks are risky in the short-term but it’s even riskier if you don’t hold them in the long-term. Cash is risky in the long-term but it’s even riskier if you don’t have liquidity in the short-term when you need to spend your money.
So how are people supposed to survive in a world in which:
- Risk perceptions are constantly changing
- Safety is often an illusion since risk never completely goes away
- Base rates can be helpful but also hold you back
- We know bad things can and will happen
Understand normal accidents are inevitable. In Normal Accidents, Charles Perrow describes the risk inherent in any complex adaptive system:
As systems grow in size and in the number of diverse functions they serve, and are but to function in ever more hostile environments, increasing their ties to other systems, they experience more and more incomprehensible or unexpected interactions. They become more vulnerable to unavoidable system accidents.
These normal accidents occur in the stock market all the time.
For instance, I know my investment lifecycle over the next 4-5 decades will be littered with recessions, corrections, bear markets and brutal market crashes. This is a feature, not a bug of our economic system.
I will likely see my stock holdings fall 40-60% a handful of times, 20-40% every 4-5 years and 10-20% every couple of years or so. Any money I have in the market will be incinerated multiple times in the decades ahead. I don’t know when and I don’t know why but I am confident this is going to happen.
But that doesn’t mean I’m going to sell all of my stocks. I just have to build an investment plan that accounts for the inevitable downturns.
You can’t predict but you can prepare. When they were testing the prototype for their first powered airplane, the Wright Brothers would always bring extra materials with them for every test run.
They knew they would inevitably have issues but didn’t necessarily know what would go wrong ahead of time. So they brought all sorts of different tools and parts just in case.1
Contingency planning is a staple of risk management because life never goes according to your original plan.
Learn to live with uncertainty. Peter Bernstein once wrote, “The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.”
Managing risk boils down to controlling what you can control and understanding some outcomes are out of your hands.
Almost every decision you make comes down to looking at all the alternatives and choosing the route with the highest odds of success.
Unfortunately, the whole point of risk is we don’t know what’s going to happen.
1The first powered flight was in 1903. By 1910 there were around 2,000 pilots on the planet. Thirty-two of them died in flight that year, meaning your chances of dying while flying were roughly 1 in 63. Today that risk is more like 1 in 11 million.