Risk perception is often about pain and not probabilities. It is about the experience of risk not the mathematical chance or size of loss. I would like to say that everything about risk management is measurable and can be reviewed dispassionately, but that is not the case. There is often a difference between fear and facts and this is the perception gap which often leads to bad judgment. You may be a dispassionate risk assessor, but the market's perception of risk may be driven by its weighted perception of the risk.
We actually know a lot about the key factors impacting our risk perception, but they are usually not discussed in investment management. Reviewing these risk perception factors is helpful at pinpointing how investors may react to different risk situations.
A number of these factors have been discussed in the writings of David Ropeik. His 14 factors influencing risk perceptions is a useful guide on how to dampen adverse risk perceptions and potential gaps with reality. These are factors are consistent with many of the behavioral biases we often discuss in finance.
Factors that affect our risk perceptions:
1. Is the source describing the risk trustworthy? - If the person or organization describing the risks is more trustworthy, our level of fear decreases.
2. Is the risk imposed versus voluntary? - Risks taken are perceived to be lower than those imposed upon an investor. I am more afraid of the driver next to me than I am of my own driving. This is a variation of the illusion of control.
3. Is the risk natural or caused by humans? - We are afraid of each other. People are more afraid of risk from humans than from nature. We are more afraid of pesticides, chemical and those things perceived not to be natural.
4. Is it a catastrophic or chronic risk? - The risk of a catastrophic disaster is viewed as riskier than something that is more likely to be such as cancer. The talk of a crash is greater than a general decline in stocks. This is a vividness bias.
5. Is the risk dreaded? - Extremely bad outcomes are given greater risk. Being attacked by a bear on a camping trip is perceived as greater than breaking a leg.
6. Is the risk hard to understand? - Anything that is hard to understand is considered riskier. New technology is viewed as riskier than existing technology.
7. Is there a high degree of uncertainty? - Anything that seems hard to quantify or explain is viewed as riskier.
8. Is the risk new or familiar? - Anything that is new is perceived as riskier over that which is familiar.
9. Is there awareness of the risk? - It seems logical that we will always feel there is greater risk with those that are known, but heightened awareness of any risk will increase our perception of the risk.
10. Is there a known victim? - If someone has been affected by a risk, our perception is that it is more likely. If you know someone who got hit by lightening, you will perceive that it is more likely to occur.
11. Will the risk affect future generations? - Risks that are associated with children are given heightened awareness.
12. Will the risk affect me? - Call it selfishness, but if we think a risk may affect ourselves it will be perceived as more real.
13. Is there a benefit with this risk-taking? If a risk is associated with perceived benefits, it will be given less weight.
14. Am I in control of the risk? Similar to those risks that are voluntary versus imposed, if we think we are in control of the risk-taking, it will be given a lower weight. Those who undertake high risk behavior just assume that they can outwit and control the risks.
Risk is always the chance of something happening times the impact of that event. While this is easy to define, it is hard to measure in practice so we often use heuristics to judge risks. Investors are not immune to the use of heuristics. We just have to be aware of the problem, take a time-out, and objectively try to measure the probability and impact of an event.