Do you take risk as reality? - Views on News from Equitymaster

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Do you take risk as reality?

Dec 3, 2008

Have you ever been caught by a traffic policeman for talking on the phone while driving? If you have, we are sure that after haggling with the guy for the next half an hour or so to get out of the mess, you have promised yourself to be much more careful from then onwards. Only to slowly become less wary as a good number of days go by without you being caught again.

This, more often than not, leads you to become more confident over time. You might start by trying to carefully talk on the phone again during times of necessity. And when you experience not being caught for an extended period of time, you would subconsciously tend to drop your guard and gradually end up boldly and recklessly talking on the phone while driving again. Well, what is happening is that the time when you are most vulnerable to being reckless again is coinciding with the time when there is the highest probability of you being caught again.

Risk may very well be a reality, but it is sometimes funny how we perceive the occurrence of events we consider risky. There is always the risk of something untowardly happening due to which our prior calculations can go for a toss, and lead us to fall into trouble. Whether that is in investing or anything else in life, the risk of anything unwanted happening is always there.

But at the same time most events have a probability of happening. It is here that the lacuna exists. The more vividly we remember an event, the more we tend to take a note of it and guard against it. And remembering an event vividly is a function of the clarity and freshness of experience in our mind. Thus if you have just witnessed a market crash, you would be understandably shaken up and be very careful and cautious about it for some time to come.

But that said, the converse also has to be true. As time goes by, our memory of an event tends to become increasingly faded. The vividness with which we recollect it keeps decreasing over the years. Thus we slowly and subconsciously drop our guard against the particular risk, leading us to take actions that are inclined towards being less circumspect. But the ironic thing is that the probability of an event occurring is the least after it has just happened.

And as time passes, the probability of it happening again steadily increases. Say if the probability of a market crash happening is about once in ten years, people will tend to be most risk averse at the start of the ten years when a market crash has just happened. And they will tend to have the highest risk appetite (and consequently be least cautious) in the ninth year. But this is a time when a crash has not occurred for the last 9 years (and has the highest probability of happening again).

So instead of that fact making us more cautious about over doing our expectations, it ends up becoming a reason for us to be even more confident. This psychological tendency gets even more exacerbated when we see everyone around us being as confident. Leading to that inevitable situation of overblown expectations, and then a sudden, loud crash.

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