About spending? About investing? About buying insurance? Do you act on your emotions? Or, do you make decisions by weighing the possibilities with the hope of increasing your chances of achieving a desired result?
More often than not, we become overwhelmed by the stress of making financial decisions and go with our gut. Impatience then steers us into making a hasty decision or, sometimes, deciding to take no action at all. When things don't go as planned, our favorite explanation is to ascribe it to luck, good or bad as the case may be.
Yet, if everything results from of luck, then making financial decisions and managing life's risks would be a meaningless exercise. Invoking luck obscures truth, because it separates an event from its cause. When we say that someone has fallen on bad luck, we relieve that person of any responsibility for what has happened. When we say that someone has had some good luck, we deny that person credit for the effort that might have led to the happy outcome. But how sure can we be? Was it fate or choice that led to the outcome?
Until we can distinguish between an event that is truly random and an event that is the result of cause and effect, we will never know whether what we see is what we'll get, nor how we got what we got!
In this letter we will try to help you develop an understanding that the essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing areas where we have absolutely no control because the relationship of cause and effect is not readily apparent or hidden from us.
Not Enough Information!
While we may assemble big pieces of information and little pieces, it always seems that we can never get all the pieces together! In addition, often we may never know for sure how good our information is. On top of that, this uncertainty always makes arriving at judgments very difficult and risky.
When information is lacking, most people fall back on inductive reasoning and try to guess the odds. Inductive reasoning often leads us to some curious conclusions as we try to cope with the uncertainties and risks we are left to take. Nobel Laureate Kenneth Arrow has done some of the most impressive research on this phenomenon. Early on, Arrow became convinced that most people overestimate the amount of information available to them. The failure of economists to comprehend the causes of the Great Depression, at the time, demonstrated to him that their knowledge of the economy was "very limited".
In an essay on risk, Arrow asks us to consider the difference between gambling versus regularly paying premiums to an insurance company. The mathematical probabilities indicate that we will lose money in both instances. In the case of gambling, it is statistically impossible to expect more than break even because the house edge tilts the odds against us. In the case of insurance, the premiums we pay exceed the statistical odds that our house will burn down or that we will be burglarized.