A very good book, Risk Intelligence: How to Live with Uncertainty by Dylan Evans, advances our understanding of risk management. Evans provides a concrete method of the measuring risk intelligence within individuals in order to help managers see their limitations at assessing probable events. This is an advancement over the direction of behavior finance which has focused on the flaws of decision making but has not provided useful tools for improvement.
The author makes the important point that there is a difference between risk intelligence and risk appetite. Risk intelligence is the cognitive capacity to assess risk and is an intellectual ability. Risk appetite is an emotional trait associated with the comfort that someone has with risk taking. Risk appetite is a taste or preference for risk. It is not good or bad, right or wrong. It is a characteristics of an individual. Risk intelligence, on the other hand, can be a learned skill. Those who show have higher risk intelligence should perform better at assessing risk regardless of the level of risk appetite. Risk intelligence is a skill that can be measured and improved. Weather forecasters are good at it. Doctor are poor at risk assessment.
Risk intelligence is about assessing the right amount of uncertainty for a specific event. It is the ability to properly estimate what is likely. We do not live in a totally certain or uncertain world, but one that has degrees of precision.
One of the key behavioral biases discussed in finance and all decision making is over confidence. Risk intelligence allows an individual to reduce any overconfidence bias they may have. Risk intelligence is not about gathering information or data to be smarter, but handicapping the information that is available to make a correct assessment of events that are still uncertain.
One of the key behavioral biases discussed in finance and all decision making is over confidence. Risk intelligence allows an individual to reduce any overconfidence bias they may have. Risk intelligence is not about gathering information or data to be smarter, but handicapping the information that is available to make a correct assessment of events that are still uncertain.
David Apgar defines risk intelligence as "the ability to reach accurate judgements about a specific new risk." Frederick Funston defines it as "the ability to effectively distinguish between two types of risks: the risk that must be avoided to survive by preventing loss or harm; and the risks that must be taken to thrive by gaining competitive advantage." Isn't this the intelligence we need to be better investors?
Evans presents a test on measuring risk intelligence. The test tries to measure how much you know about specific facts. Specifically, can we properly measure not one's knowledge but our ability to understand our certainty of what we know. Testing can measure whether the proportion correct in a knowledge test matches our probability estimate. Someone who has perfect risk intelligence will be able to properly calibrate what they know with what they think they know.
We are actually pretty good at making these assessment when we have games which require specific probability skill. Those tasks that are not naturally probability based is where most people have problems. Testing usually shows that we are overconfident in our knowledge. In this context, our probability estimate of what we think we are certain about is much higher than reality. We are good at handicapping what we do not know, but those things which we are most certain about may actually not be true. Improved risk intelligence will help with calibrating our probability assessments to match reality. Risk intelligence helps us generate measures of subjective certainty that is consistent with the actually probabilities of events. Unfortunately, many either provide subjective certainty that moves from extreme states that they are absolutely sure of events, or have no idea of certainty and stay in a state of ambiguity where everything is flip of a coin. Risk intelligence tries to increase our spectrum of certainty judgment.
We fall into decision trap when we do not assess risk properly. A good example of a simple trap is worst case thinking for making decisions through placing emphasis on the what may go wrong at the expense of measure the chance that something may go right. We move to an extreme and do not calibrate risk. The same problem excise when we put emphasis on all or nothing statements which move to extreme thinking.
Evans is an original thinker who advances thinking about risk calibration. We should see more work like this in order to improve or risk intellect.
We are actually pretty good at making these assessment when we have games which require specific probability skill. Those tasks that are not naturally probability based is where most people have problems. Testing usually shows that we are overconfident in our knowledge. In this context, our probability estimate of what we think we are certain about is much higher than reality. We are good at handicapping what we do not know, but those things which we are most certain about may actually not be true. Improved risk intelligence will help with calibrating our probability assessments to match reality. Risk intelligence helps us generate measures of subjective certainty that is consistent with the actually probabilities of events. Unfortunately, many either provide subjective certainty that moves from extreme states that they are absolutely sure of events, or have no idea of certainty and stay in a state of ambiguity where everything is flip of a coin. Risk intelligence tries to increase our spectrum of certainty judgment.
We fall into decision trap when we do not assess risk properly. A good example of a simple trap is worst case thinking for making decisions through placing emphasis on the what may go wrong at the expense of measure the chance that something may go right. We move to an extreme and do not calibrate risk. The same problem excise when we put emphasis on all or nothing statements which move to extreme thinking.
Evans is an original thinker who advances thinking about risk calibration. We should see more work like this in order to improve or risk intellect.
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