In other words, our perception of risk isn't always grounded in reality.

TO BE NOTED: FROM THE FRONTAL CORTEX VIA PAUL KEDROSKY:

"Risk as Feelings

Posted on: March 23, 2009 12:59 PM, by Jonah Lehrer

Brad Delong summarizes an important point when it comes to evaluating whether or not the latest plan to rescue banks from their own toxic assets is going to work. In this interesting post, he contrasts his own tepid support for the plan with Paul Krugman's pessimistic opposition:

I think the private-sector players in financial markets right now are highly risk averse--hence assets are undervalued from the perspective of a society or a government that is less risk averse. Paul judges that assets have low values beceuse they are unlikely to pay out much cash.

I think one way to evaluate these dueling positions is to look at how people generate perceptions of risk. Investors have concluded that these toxic assets are simply too risky to invest in, at least without large infusions of government money. How rational are these perceptions of risk? Are investors wary of buying toxic assets because they have good evidence that the toxic assets are virtually worthless? Or are they wary of these investments because they're irrationally scared?

There's certainly no shortage of anecdotal evidence that people can misperceive risk. Look, for instance, at the very common fear of flying: More than 30 percent of people admit to being "scared or very scared" whenever they board a plane. And yet, according to the National Transportation Safety Board, flying on a commercial jetliner has a fatality rate of 0.04 per one hundred million passenger miles. In contrast, driving has a fatality rate of 0.86. This means that the most dangerous part of traveling on a commercial flight is the drive to the airport.

In other words, our perception of risk isn't always grounded in reality. Where, then, does the sense of riskiness come from? I think one of the most convincing theories of risk perception comes from the work of George Loewenstein, of Carnegie Mellon. In 2001, he co-authored a quite interesting paper that looked at risk through the prism of emotion. Here's the abstract:

Virtually all current theories of choice under risk or uncertainty are cognitive and consequentialist. They assume that people assess the desirability and likelihood of possible outcomes of choice alternatives and integrate this information through some type of expectation-based calculus to arrive at a decision. The authors propose an alternative theoretical perspective, the risk-as-feelings hypothesis, that highlights the role of affect experienced at the moment of decision making. Drawing on research from clinical, physiological, and other subfields of psychology, they show that emotional reactions to risky situations often diverge from cognitive assessments of those risks. When such divergence occurs, emotional reactions often drive behavior. The risk-as-feelings hypothesis is shown to explain a wide range of phenomena that have resisted interpretation in cognitive-consequentialist terms.

Here's an elegant example of how perceptions of risk are largely driven by our emotions, which makes use of a simple investing game invented by Baba Shiv, Loewenstein and colleagues. In each round, experimental subjects had to decide between two options: invest $1 or invest nothing. If the participant decided not to invest, he would keep the dollar, and the game would advance to the next round. If the participant decided to invest, he would hand a dollar bill to the experimenter. The experimenter would then toss a coin in plain view. Heads meant that the participant would lose the $1 that was invested; tails meant that $2.50 would be added to the participant's account. The game stopped after 20 rounds.

If people were perfectly rational⎯if they made decisions solely by crunching the numbers⎯then

subjects should always choose to invest, since the expected value on each round is higher if one invests ($1.25, or $2.50 x 50 percent) than if one does not ($1). In fact, if people invest on each and every round, there is only a 13 percent chance of making less money than if they never invest and simply pocket the $20.

So what did the subjects in the study do? Those with an intact emotional brain chose to invest less than 60 percent of the time. Because we are wired to dislike potential losses, most people were perfectly content to sacrifice profit for security. In other words, they were irrationally risk averse. Furthermore, the willingness of people to gamble plummeted immediately after they lost a gamble⎯the pain of losing was too fresh. This is roughly analogous to where we are now: investors have just lost a lot of money in the market, and they're unwilling to make any new investments, even if the investments might be profitable over the long-term.

So far, so obvious. The flight to safety has happened countless times before. But the scientists didn't stop there. They also played the investing game with neurological patients who could no longer experience emotion. If it was a feeling that was causing these bad investing decisions, then these patients should perform better than their healthy peers.

That's exactly what happened. The emotion-less patients chose to invest 83.7 percent of the time, and gained significantly more money than normal subjects. They also proved much more resistant to the misleading effects of loss aversion, and gambled 85.2 percent of the time after losing a coin toss. In other words, losing money made them more likely to invest, as they realized that investing was the best way to recoup their losses. In this investing situation, being numb to their emotions was a crucial advantage.

So what should we do? I'm not advocating lobotomies for hedge fund managers. (In most instances, not being able to experience emotions is a profound handicap.) And, of course, there's also a good possibility that investors might have correctly perceived these toxic assets as too risky. (The name certainly doesn't help.) But I think it's important to keep in mind that our perceptions of risk are fallible feelings, so that these assets might be undervalued because investors are, at the moment, irrationally risk averse."