The Importance of Developing Risk Policies

In his book Thinking, Fast and Slow, Daniel Kahneman includes a chapter titled Risk Policies. If you are someone who has put off creating risk policies and made risk management decisions based on gut-instinct for a number of years, you may find what Kahneman has to say a watershed moment for your business.

To understand this, a background understanding of what Kahneman calls Prospect Theory (and many others, including myself, refer to as Regret Theory) is in order. In general, Prospect Theory says that a person values losses differently than gains. For example, offered a decision between a sure gain of $240 and a coin flip that rewards $500 for a heads and $0 for a tails, a majority of people will take the $240. On the other hand, if the choice was between a sure loss of $260 and a coin flip that will cost you $500 if the result is tails and $0 if the result is heads, a majority of people will take the gamble. In other words, people are much more willing to gamble to avoid sure losses than they are to give up sure gains in order to gamble.

In this example, the result is the same in either case and a person’s decision to take the gamble or not should be the same regardless whether the question is asked in the context of a sure gain or a sure loss. Note that in the case of a sure gain of $240, the decision maker is comparing it to a possible 50/50 gamble that could leave them $260 richer/happier if it turns up heads or $240 poorer/regretful if it turns up tails. In the case of the sure loss of $260, the decision maker is comparing it to a 50/50 gamble that could leave them $260 richer/happier if the result turns up heads or $240 poorer/regretful if the result turns up tails.

Logic says that people should consistently take the gamble or not regardless of whether it is described as a loss or a gain but that is not how a majority of people behave when faced with these decisions on a one time basis.

The key point when it comes to Prospect Theory and the importance of developing risk policies is that the above decisions which were posed as one time decisions are quite often repeated decisions in reality. If we knew that the decisions and, therefore, the gambles were going to be offered repeatedly over a long period of time, we would be much more inclined to weigh the sure bets against the expected value of the gamble when making the decision. In other words, we would not let our emotional propensity to avoid losses come into play in such a big way as they do in one time gambles and we would be more logically consistent.

As Kahneman poses, a risk policy where this might come into play is a policy to never buy extended warranties. Quite often, when faced with the decision whether or not to buy an extended warranty on an item we are purchasing, we fear the worst. We picture ourselves with a worthless broken down item one day after the standard warranty has run out. Emotionally, our desire to avoid such a feeling of loss pushes us into purchasing extended warranties even though we know logically that the cost of the extended warranty will likely far exceed the expected payout associated with collecting on it.

We are commonly faced with a decision on purchasing an extended warranty multiple times a year. A risk policy that says to never buy an extended warranty makes sense if this is the case. The money saved on the extended warranty costs will likely more than cover the cost of a periodic failure of one of the items purchased. This is not a shocking development as most us know that over the long run our insurance costs typically outpace our insurance indemnities. The key is to develop an understanding of our ability to absorb each particular loss. In many cases, we are much more capable of doing that than we give ourselves credit for financially. In the absence of a risk policy, we let emotions rule the day and push us into decisions inconsistent with the logic of good risk management decision making.