How We Think About Risk
Last week, I got a text from my financial planner reminding me that my parent’s health insurance is due for renewal.
This brought up a discussion about switching insurance providers for my parents.
The current provider, although the cheapest in the market, has a reputation for not approving claims because of various technicalities and refusing to cover someone after they’ve made a large claim.
The new provider, a large reputable insurance company, has a more reliable claims process. But the catch is – the premiums are 3 times higher than what I’m currently paying.
Herein lies my dilemma.
Do I stick with the current provider because it’s cheaper but risk not being able to claim a large hospital bill in the future?
Or do I suck it up and pay the higher premium now, and mitigate said risk?
In personal finance, we’re constantly faced with money dilemmas like this.
And a lot of how we decide what to do, the choices we make, boils down to how much risk we THINK we can handle.
We overestimate our risk tolerance when things are going well
It’s human nature to think bad things won’t happen to us.
Occasionally, we neglect to wear our seatbelts while driving. We tell ourselves snacking on an extra piece of cake won’t hurt anyone. We delay building our emergency fund in favour of spending money on a holiday.
When we do something once, twice, three or more times and get away with it, we start to develop a belief that we’re invincible. Our optimism gets the best of us.
But these actions, deliberate or reckless, increase the probability of a certain risk. It’s just that we can’t see that probability increasing.
Not wearing our seatbelts increases our odds of a critical injury in an accident by almost 50%. Eating one too many pieces of cake increases our chances of becoming diabetic. Without an emergency fund, we risk putting ourselves in a difficult financial situation.
We think, “That won’t happen to us”.
Because of this sense of invincibility, we overestimate how much risk we can tolerate when things are going well.
When I first moved to Singapore, I didn’t have any health insurance for over a year. When I finally – and reluctantly – bought a health plan, 9 months later I got hit with a medical diagnosis that required a hospital procedure. Luckily, I had the insurance to cover the medical bills.
All of a sudden, I am acutely aware of the risk I took by not having insurance in that first year.
And just as suddenly, I am more inclined to categorise myself in the percentage of people that got diagnosed with that illness, when just a year earlier I thought I never would have gotten it.
We judge an event as more probable when we can readily remember it happening before.
And that affects our perception of risk.
We’re prone to recency bias
With recency bias, we remember things that happened recently more easily than things that happened a while ago. So, when things are going so well for so long, recency bias lulls us into complacency.
If you entered adulthood during the 10-year bull run after the 2009 financial crisis, the US stock market has done well for the majority of your adult life.
You might end up thinking that putting more and more money in the stock market is a surefire way to gain financial independence.
Indeed, the FIRE movement – the idea that if you save aggressively enough, those savings can generate enough returns every year for you to live off comfortably – was born out of that bull market. And the fact is, many people did reap the rewards of doing this.
But what if you entered adulthood and started investing in January 2020, right before the pandemic? Or what if you started investing in January 2022, right before Russia invaded Ukraine?
In the last couple of years, we’ve seen people swing wildly from being risk-seeking to risk-adverse.
With persistent inflation, and elevated interest rates, the pain of a higher cost of living and (if you’re invested) the pain of losing money is still very fresh in our minds.
We feel this pain more acutely and make decisions based on our recent memories.
Many folks I know stopped investing this year. They decided to sit on the sidelines and wait for the opportune moment to start investing again. All while the S&P 500 climbed 23% year-to-date.
Maybe the decision to sit out of the market has less to do with our ability to take risks.
Maybe it had more to do with the fact we got burnt in the market last year and the wounds are still too fresh for us to want to try again.
Nothing is guaranteed
No matter how comfortable we think we are with risk, nothing is guaranteed.
And that’s a frightening notion.
We don’t like living in a state of flux because it’s hard for us to comprehend our future when we don’t know what’s going to happen next. We like certainty.
So we try to make sense of our situation by seeking templates on how to manage our money and our lives.
We ask questions like, “How much returns can I expect with this investment?” or “Is now the right time to invest?”
It’s hard to answer these questions because no one knows.
Sure, economists can give you a forecast but forecasts aren’t predictions and can’t be taken as gospel. As the past few years have demonstrated, basically anything can happen.
Nothing is guaranteed, not just in investments, but in life too.
Despite this, why do so many people, myself included, take the risk of going without some form of financial protection like insurance?
We don’t know how future pain feels like
Pushy insurance agents aside, a glaring reason people don’t want to pay for financial protection is the absence of a reward or a payoff.
Unlike investing, where the prospect of financial gains fuels our enthusiasm, there is no tangible positive outcome with insurance. Even if you get a death benefit payout, it is accompanied by tragedy.
Not only is there no reward with insurance, but our brain also tends to downplay potential pain until it becomes a tangible reality.
The abstract nature of future risks doesn’t evoke the same urgency as immediate concerns.
If anything, we experience more immediate pain when we pay our premiums every month. It feels like a waste of money, especially when the future pain we’re trying to avoid feels intangible.
In investing, pain manifests in a much different way – it’s often associated with the fear of missing out on potential profits. This fear compels people to take more risks to pursue gains.
As Michael Batnick puts it:
In a bull market, protecting one’s downside gets punished, and after being burned enough times, people tend to lighten up on risk management, or abandon it altogether.
This doesn’t happen suddenly, it slowly builds over time. In a bull market the more risk you take, the more you’re rewarded, and the more you’re rewarded, the more you forget about risk.
Minimise future regret
It’s useless to look back on the risks we took and say to ourselves, “If only I did this, I could have avoided that”.
The solution to how I make decisions lies in that statement itself.
We feel regret for doing or not doing something, so I’ve chosen to approach my decisions and optimise my life to minimise future regret.
This is a mental model put forth by Jeff Bezos:
The framework I found which made the decision incredibly easy was what I called the regret minimization framework.
I wanted to project myself forward to age 80 and look back on my life and I want to have minimized the number of regrets I have.
How to move forward
While we can’t foresee every risk in life, what we can do is prepare to mitigate some of the more obvious risks so that dealing with whatever comes next will not feel as painful or regrettable.
Here’s how you can be prepared:
- Prepare to be unprepared
It might be a bleak way to look at things, yet I firmly believe the sooner we embrace the fact that everything – our money, our jobs, our lives – can vanish in an instant, the easier it will be for us to deal with and prepare for uncertainty. Well, that’s the case for me, at least.
- Be calculative about risk
There’s no way to live life avoiding risk altogether but what we can do is choose to accept some degree of risk.
But knowing what risks to take entails knowing the likelihood of our gain and our loss and how those will impact our mindset and behaviour afterwards. These things are difficult to predict, especially when we tend to be optimistic about our probability of success when we take risks.
In every decision you make going forward, whether financial or otherwise, take a moment to ask yourself:
“What is the likelihood of upside and downside that can result from this decision?”
Then, “What actions can I take to reduce the probability of the downside happening?”
Also honestly ask yourself, “Can I live with the downsides?” and “Will I regret doing this / not doing this?”
- Build an emergency fund
An emergency fund is really the least we can do to stay out of financial trouble.
It can be difficult for some of us to even begin saving up money, let alone have 6 months of expenses socked away for a rainy day but every little bit counts.
1 month of emergency funds is better than nothing.
And if you’re thinking of investing money without having an emergency in place first. Don’t. That risk isn’t worth taking.
- Get protection, even just a little bit
I feel like I wrote this entire piece to convince myself that paying for insurance is necessary to safeguard my long-term financial well-being.
Even though I much rather spend the money on something else that provides immediate pleasure or invest it, these actions would not help me limit my future regret.
If you can’t afford to pay for comprehensive coverage, even just a basic health plan that fits your budget will go a long way in helping you reduce your future regrets.
Final words
Risk and our perception of risk are complex subjects. How much risk you take (both in life and investments) is not something anyone can give you a clear-cut answer to. There are guidelines, of course, but it’s up to you how you want to apply them to your life.
But by acknowledging the interconnectedness of our choices and their potential consequences, perhaps we can start building a more mindful approach to our decision-making so that we can live with fewer regrets.
