Saturday, 3 November 2012

Risk Intelligence - the consequences of our confidence



I have just completed reading the book Risk Intelligence by Prof. Dylan Evans and have found it to be an interesting read. The central theme of the book talks about how much we are rewarded when we are right, and how much we are punished when are wrong. It  argues that for many executives in power today who have autonomy in making large scale decisions, understanding one's risk intelligence may be more important than having expert knowledge over a professional field. 

So what exactly is risk intelligence? It is defined as the ability to estimate probabilities accurately and having the right amount of certainty to make educated guesses.  In today's environment, it is a complex skill as everyone is working on limited information in an increasingly uncertain world.

There are some key takeaways from the book which i found to be particularly interesting: 

Most people are poor in assessing probabilities.

- Things one learn by developing high risk intelligence in one area can spill over to other areas of our lives. (E.g tertiary educated people are less likely to participate in high risk and low return activities like smoking, gambling, unprotected sex compared to their less educated counterparts). 

Risk appetite is an attitude towards risk while risk intelligence is a cognitive skill. 
Having a high risk appetite and  low risk intelligence is a certain recipe for disaster. On the other extreme, there are the risk averse lot who are constantly seeking more information that they are stuck in analysis paralysis and never gets any real work done. 
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It is also advocated that one can create some simple yet effective systems to greatly enhance results in our professional and personal lives. These strategies aim to reduce our loss exposure in times of weakness  and  maximise our gains in times of strength. Some examples include: 

Setting a threshold - Choosing to take action when one have 60%/70%/80% chance of success.  This prevents one from taking a position simply for the purpose of finding a quick buck or chasing losses.

Bet sizing - Placing amounts of wagers proportional to one's level of confidence. It is therefore possible to achieve a net positive return even if one is right only 1 out of 10 times when he is "all in" .  This is the most profitable option if one has a high risk intellligence. 

Expected Value - Knowing what events are of pure chance compared to events where superior skill is rewarded. In reality. this is not as simple as it seems, there are still a lot of smart people who believe they can beat the house in a casino, or raid the stock market by following certain " trading systems". Common sense is not so common after all. 


When does one hold, fold or bet the entire farm? 

The core idea about risk intelligence involves knowing oneself  and our limitations and is vastly different from academic intelligence.  As a result, top students who are often rewarded in school for knowing things may find themselves having a low risk quotient due to an overconfidence in their abilities.  On the other hand, average students may find themselves scoring higher on the risk intelligence scale due to a more accurate self assessment of their abilities. 

With the influx of new insights on behavioural economics, the science of decision making may have just taken a new step forward.  Readers who would like to find out their risk quotient can take the test at www.projectionpoint.com

Read related articles:
Are young people investing or gambling? 
Why young people should NEVER invest their CPF savings

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