Risk management is all about addressing problems before they happen, but what if the problem that needs addressed is you? There is no better magician than your own mind, playing tricks on you on a regular basis and leaving you none the wiser. When it comes to judging risk though, these tricks can be harmful. Dylan Evans of the Harvard Business Review helps you get in on the act to learn when you have over or underestimated the risks in your work.
In his blog post, Evans calls specific attention to a phenomenon known as the favorite long-short bias, first observed in 1949 and elaborated upon in 1979. What was discovered is that people tend to perceive differences between extreme probabilities much better than they do differences between intermediates ones. Evans gives the example that we are willing to pay much more for a medical operation that increases our survival chance from 0% to 1% than we are for an operation that increases it from 10% to 11%. Similarly, paying more for a lottery ticket that shifts odds from 99% to 100% seems more agreeable than paying for a shift from 89% to 90%.
As a result, in gambling, people are willing to bet more on long-shots than is rational, and bookies are happy to see a long-shot win because that is when they make the most money. Evans continues:
According to data published by Erik Snowberg and Justin Wolfers, in their article “Explaining the Favorite-Long Shot Bias: Is it Risk-Love or Misperceptions?,” there’s an oversensitivity to small changes in likelihood at both ends of the probability spectrum — for very short and very long odds. Betting on horses with odds between 4/1 and 9/1 has an approximately constant rate of return (at minus 18%), which implies that bettors are quite good at distinguishing between probabilities over this range. It is only when punters bet on favorites (with odds shorter than 4/1) or long shots (with odds longer than 9/1) that they get into difficulties.
To overcome this little quirk in our perspective, Evans suggests the answer is mathematics. Numbers do not lie—assuming you are using the right calculations and mathematical models to support your perspective, which is not always the case. That is to say, you should not sell yourself short either. Hard numbers backed up by a little common sense is the winning combination to pull the curtain on your risk misconceptions.