Losing your shirt: The importance of understanding risk
Fri 30 Apr 2010 by Infometrics Ltd.

Why do finance companies seek high profile politicians and other celebrities as directors and promoters?  Well that’s obvious isn’t it? They present a familiar and trusted face to the potential investor.  If respected individual is seen to be associated with a company, it must be good. Not much chance of losing one’s shirt there. However, as big name finance company failures demonstrate this assessment is not accurate.

The ruse works because people’s understanding of financial risk is generally poor.  We wouldn’t follow a celebrity onto a rickety bridge, so why follow them into a rickety financial deal?  We seem to be able to assess the risk of the bridge much more clearly than we can assess the risk of the finance company.

Much of the way we think is based on generalisations, implicitly assuming that the past is a guide to the future.  For example, will the bus come on time tomorrow even though it has been late for the last three days?  We can roughly assess the chances of an event with which we’re familiar, but when that familiarity is lacking we look to other sources for information and guidance – sources such as celebrities.  But is our understanding of financial risk that bad?

A report last year from the Office of the Retirement Commissioner noted that only 43% of New Zealanders score highly on financial knowledge.  Sixteen percent have difficulty managing money, but in the low knowledge group that proportion is 26%.  Further reading of the ORC report reveals that it is not so much poor financial skills that are the problem, but poor numeracy (and literacy) skills in general.  One can see from NCEA mathematics results that a key weakness in numeracy skills is the comprehension of probability, which is absolutely crucial to understanding risk.

Consider an example. You know that your friend has two children.  As you approach his house one of the children, a girl, comes running out to meet you.  What is the probability that the other child is a boy?  Well everybody knows that the odds of having a boy or a girl are about 50/50, so the probability must be 50% – correct?  No, the answer is in fact 67%.  To see why this is the case consider the following diagram which illustrates the problem.

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Before you saw the girl you knew that there was a 25% chance your friend had two boys, a 25% chance of two girls, and a 50% chance of a boy and a girl.  As soon as you saw a girl approaching the ‘two boys’ possibility is ruled out.  The three possibilities remaining are BG, GB and GG.  Two out of these three possibilities involve a boy, so the answer to the question is two-thirds or about 67%.

This example is reasonably straightforward, but still somewhat counter-intuitive.  And at least there was some prior information –the number of children was known.  Imagine how much more difficult it is when risk is unknown and each event is not discrete (such as having a girl or a boy), but can vary over a continuum, such as the rate of return on an investment in a finance company that itself has investments in other companies of unknown risk. How can one solve complex issues that involve optimising over time, such as how much to save for retirement and where to save it?  What does ‘low risk‘ actually mean – that you lose your money on one out of every ten investments, that every tenth person loses their money, but probably not you?  Even if we understand the risk, can we assess its cost?  We know the value of losing what we’ve put in, but what about the value of what we haven’t gained.  Who wants to .be earning 5% on a bank deposit when your neighbour is earning 8% in a finance company.  Never mind that the 8% is riskier.  Former politician X or former All Black Y say it’s fine.

Returning to the boy-girl example, the prior knowledge that one’s friend had two children is all important.  With the regard to financial investments that prior knowledge is frequently lacking, sometimes because of deliberate misrepresentation, sometimes because of a lack of transparency.  New regulations governing the finance industry and financial advisers are intended to lead to more information being divulged to potential investors and to reduce the chances of investors receiving bad advice by clarifying who is responsible for the privation of information.  However, regulation can only go so far in combating the effects of inadequate knowledge about financial risk.  Thus the expansion of financial literacy programmes in schools is most welcome.  So too is the obligation on KiwiSaver providers to pass more stringent tests than finance companies.  Fundamentally though the Kiwisaver situation is still one where investors trust others to have a better understanding of risk than themselves.  One hopes that investors look beyond just the names who are the public faces of the providers and determine which ones are actually financially literate.  Otherwise those envisaged lump sums at age 65 may not eventuate.

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