Do consumers understand risk?

Brendan Burgess

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The Society of Actuaries is having a [broken link removed]on this topic on Thursday 23rd November


 
It's an excellent question. I don't believe my own generation (I'm 31) and younger have any notion of risk particularly with regard to property and debt in general. Why would they when everything has worked out so far? (run into problems = top-up the mortgage... again)

As for other financial products i think there's a keen cynicism about being 'ripped off' but little appreciation of an individuals own responsibility to look at risk and weigh up the pros and cons for themselves.
 
I think it's pretty obvious that a large proportion of society have absolutely no concept of risk, whilst for many others their concept of risk has been skewed by a number of abnormal circumstances during the last 10 years: Dot com boom/bust + Eircom = the stock market is high risk and gives low returns, 10 years of yoy house price growth = property is low (zero) risk and makes massive returns.

I would say that this may simply be a product of us being a smallish nation. Lessons are generally learned very quickly, whether they are correct or not, and accepted truths become gospel overnight.

This poster was told the mortgage product he was being sold was less risky than others, and because the numbers fitted his circumstances he bought. 4 years down the line he's looking at a 39% increase in his endowment payments.

http://www.askaboutmoney.com/showthread.php?t=41218

The risk associating with this, or any product, doesn't change much over time, people's perception of what that risk level actually is does.
 
The answer is NO. To understand risk, you must have some appreciation of probability and statistics. Even this isn't enough as the insurance and life companies (who presumably employ most of the members of this society), brokers and the likes of the lottery exploit a common psychological weakness in their marketing campaigns. The sales/marketing trick is effective and common - you need to get your target to mentally picture something improbable happening to them. Many people have powerful imaginations which can often override their analytic side so that even if they know the probabilities and understand basic stats, they will be guided by the emotions associated with the mental picture. This works just as well to get people to buy lottery tickets ("picture it - it could be you!") as it does to get people to buy ridiculous insurance products ("picture what would happen your family if X were to happen" says the broker gravely) but at least in the former case the sums involved are typically very small.
 
In general consumers do not understand risk. But, there's also a strong element of head-in-the-sand-when-it-suits-them. There are quite a few who might understand risk but just hope to god it doesn't happen to them, and then blame someone else when it goes wrong.

One problem is that, even if they understand it, most consumers cannot stomach risk. Isn't there some theory about people putting much more value on avoiding downside risk than getting an extra return?

The basic financial principles that people need to learn are

(i) To gain reward you have to take risk. If the reward seems high, you are most likely taking a higher risk.

(ii) Don't put all your eggs in one basket.

Perhaps this can the regulator's next ad campaign.
 
czechmate said:
To gain reward you have to take risk. If the reward seems high, you are most likely taking a higher risk.
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Partly but not always true. Risky investments can sometimes offer low rewards.

My own, non-professional observances in this area have led me to think that people are unduly optimistic. They will generally plan on getting the best possible results, even if they're told that there is a possiblity for negative results. I think it has more to do with selective hearing and greed than lack of information availiable to investors.
 
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(i) To gain reward you have to take risk. If the reward seems high, you are most likely taking a higher risk.
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Counter example: hedge funds are low risk and beat the market.

To gain reward you must take on the right type of risk. Taking on uncompensated risk is foolish.

There are a lot of misconcptions about risk. The term is used too often for different things. Some people look at risk as being variance, Ben Graham would disagree. Others take risk as being Beta, Warren Buffet would laugh at you.

Others use it when investing/trading for placing stoplosses. I think the stock will go up $2, but if it goes down $1 I'll get out. Therefore my risk to reward ratio is 2-1.....Ehm no, it's not.
 
RedJoker said:
One example out of approx. 3000 hedge funds does not prove that hedge funds are risky. Occasionally planes crash aswell, but they're still safer than cars.
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That analogy is more than a little disingenious. Just because the likelihood of a hedge fund going bust is low does not imply investing in hedge funds is low risk. Amaranth may be one of the few hedge funds to have completely imploded but that does not mean no other hedge fund has ever lost money. Leveraging is a double-edged sword and a heavily leveraged fund must be seen as an inherently risky investment.

A low risk investment implies (to my mind at least) very little chance of incurring losses on the capital sum invested - high grade bonds and cash deposits spring immediately to mind. Hedge funds almost certainly do not fall into this category.
 
The pay-off for assuming risk is return. In all aspects of life, if you risk nothing you tend to get nothing in return. I believe this to be true for relationships, business, health, etc. you name it. “Success” in life can be defined as the lifelong outcome of consistently maximising the return to risk trade-off. Unfortunately I do think this is mostly an inate and automatic thing, a natural instinct or awareness, an aspect of intelligence, but it probably can be learned/improved. Silver spoons and good genetics aside, we all know individuals who seem to always come up trumps and we all know ones who always seems to get the short end of lifes stick. You can be lucky, even massively lucky, but over the course of a persons lifetime overall success will revert to the ability to assess this trade-off.
 
I'm a firm believer in the concept of applying a sound risk policy towards personal financial management. Recently i've found myself trying to explain the risks associated with over exposure to market varialbles particularly to people involved in house market speculation (amateurs) only to be faced with blank faces and being branded a pessimist.

It seems to me that Irish soceity in general, and particularly the under 30s, have no idea of how an economic slump may effect them and are simply amassing huge amounts of credit so as to keep up with the good times. I was listening to FM104s Adrian Kennedy show (a bit sad but sometimes its entertaining) and he was discussing personal debt and you would not believe the amount of people between 18-25 that had run up debts exceeding 20k with nothing to show for it. One lad had even considered declaring bankruptcy at 18!!!!

I think if there going to start introducing road safety lessons in school that might want to consider throwing in a few risk management classes too!!!!
 
the lack of appreciation of risk displayed by some ppl can be quite frightening...be it with regard to property or stocks or specualtion.

But, there is also alot of money professionals who also have very bad concepts of risk, be it systematic or market risk. And all the risk measures in the world are only as good as the ppl interupting them. I mean, how many of the large, sophisticated big bulge banks have been hit by traders/portfolio managers gaming the var and such.

I think w2w described risk measures accuratlery, as being a consistent and concise method of measuring the payoff of projects of the same risk profile, be that profile betas or sharpe ratios or variance or so on...
 
The seminar relates to consumers of financial services, investment and pension products. I looks like it will be very interesting. Im very interested in the session entitled Communicating risk: Judges, Juries and Journalists.

 
In my experience, people just plain don't understand risk at all. I've been involved in environmental pollution risk assessments, where things have been classified as "very low risk" but what people jump on is that there is a risk involved; then you get the scare-mongering articles "risk of [X] at [Y]"... and then you have the demands to prove that the very low risk event won't ever happen no matter what, because people have a severely skewed perception of the implication of risk. And you get demands for horrendously expensive ways of mitigating risks which are very very remote anyway.

Conversely, people seem not to understand or deal with the concept of financial risk - if the word was better highlighted in relation to large financial transactions, people might manage their own exposure better, especially in relation to share dealings and property transactions. "WARNING: there is a real RISK that the value of your investment may go DOWN as well as UP. Take independent financial and legal advice in relation to the RISK you are taking" might be a suitable sort of public health warning in relation to large transactions. [Alternatively "Investing in the dark may make you very poor"]

I can't get over the number of people who make five and six figure commitments ("because it's a sure thing") without either doing their own research or spending a few hundred euro on good advice - and why don't they get the advice? Because they can't afford it. I ask you...
 
Dreamerb said:
In my experience, people just plain don't understand risk at all.
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A good book on understanding risk, while it does not deal with financial risk, is 'Reckoning with Risk' by Gerd Gigerenzer.
http://www.amazon.co.uk/Reckoning-Risk-Learning-Live-Uncertainty/dp/0140297863/sr=8-1/qid=1163806930/ref=sr_1_1/203-7167060-0381552?ie=UTF8&s=books
 
RedJoker said:
Counter example: hedge funds are low risk and beat the market.
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Goldman Sachs Flagship Hedge Fund Falls 11.6 Percent

http://www.bloomberg.com/apps/news?pid=20601087&sid=a8NuCSlNzl00&refer=home

 
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