Sunday, September 21, 2014

Wild about Risk

Most people do not feel the same impulse to go out and buy insurance, or diversify their investments, as they do to buy a sofa or new clothes. They should, but they don't. Insurance, investment, and banking institutions have historically had to fight an uphill battle to get individuals, businesses, and government to pay for risk management. Their successes, while impressive, remain incomplete: people still have difficulty facing the inherent risks and uncertainties about their economic future.

This is why almost every advanced country has mandatory social security and health insurance programs. Of course, people are not really unaware of life's big risks. We simply ignore them for reasons that are rooted in human psychology.

The link between intellectual recognition of risks and the impetus to act against them is mediated by fear: we have been programmed over millions of years of evolution to take decisive action against immediate and obvious threats. If a menacing wild animal approaches, we feel fear and anxiety. Adrenaline flows, our attention is focussed, and our instinct to protect friends and family aroused.

But more remote risks simply do not stimulate our emotions, so we often postpone taking action indefinitely. We are also more afraid of well-publicized risks - especially those that can kill us in grisly ways. After the September 11, 2001, terrorist attacks in the US, many Americans drove to distant locations rather than fly, even though statistics showed that flying remained far safer. Meanwhile, many of these same people were probably among the millions of Americans who didn't get an annual medical check-up.

Measuring risks, especially important long-term ones, is imprecise and difficult. Virtually none of the economic statistics reported in the media measure risk. To fully comprehend risk, we must stretch our imagination to think of all the different ways that things can go wrong, including things that have not happened in recent memory. We must protect ourselves against fallacies, such as thinking that just because a risk has not proved damaging for decades, it no longer exists.

Yet another psychological barrier is a sort of ego involvement in our own success. Our tendency to take full credit for our successes discourages us from facing up to the possibility of loss or failure, because considering such prospects calls into question our self-satisfaction. Indeed, self-esteem is one of the most powerful human needs: a view of our own success relative to others provides us with a sense of meaning and well-being.

So accepting the essential randomness of life is terribly difficult, and contradicts our deep psychological need for order and accountability. We often do not protect the things that we have - such as our opportunities to earn income and accumulate wealth - because we mistakenly believe that our own natural superiority will do that for us.

This tendency is especially apparent when it comes to public policy. Government leaders find it hard to address economic risks to the nation because it is impolitic to call into question the self-esteem of their constituency. But no one who looks at the matter seriously can argue that the tremendous inequality between the world's nations reflects fundamental differences in inherent ability or immutable character.

The per capita GDP of India in 2000, for example, was only 7% of that of the US. Can anyone believe that this is because Americans are 14 times smarter or 14 times better in character than Indians? Obviously, these two countries' relative positions are due to circumstances that can be changed, or that will change in response to economic events and political decisions.

But the leaders of the world's rich countries have great difficulty addressing risks to their relative success vis-à-vis less developed countries, because national self-esteem is too tied up with it. Citizens in advanced countries just can't believe - and don't want to be told - that their privileged status may be dissipated unless proper steps are taken to insure against the risks they face.

For example, the world's advanced countries are scarcely less dependent on oil today than they were in 1973, when the OPEC embargo stifled their economies and sent prices soaring. Despite occasional efforts at conservation, rich countries always go back to "business as usual."

Most companies are no better at managing or even recognizing the different kinds of economic risks that their workers face. Many maintain insurance and pensions for their employees, but also encourage their workers to trust the company to provide for them forever, and even to invest in the company's stock. When an employee is laid off in middle age, or the company goes bankrupt, the suddenly materialized risk may come as a shock.

Clearly, establishing mandatory social security and health insurance programs, and a social safety net for the poor, has helped hedge the most fundamental risks that people face. The problem is the lack of any coherent policy for ensuring that individuals are protected against a broader array of economic risks to their incomes, investments, and homes.

So new risk management institutions need to be devised. They should use markets, rather than state guarantees, and while they should not be mandatory, they must be designed in accordance with humans' psychological limitations, so that people will use them. We know enough about risk perception to recognize that helping people cope with the risks of modern life requires addressing their hearts as well as their heads.

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