Jason Apollo Voss was into active fund management, and is now the chief executive officer of Deception And Truth Analysis (D.A.T.A.), Inc. In a blog post years ago, he got me thinking about this when he pointed out the tremendous importance of context in understanding risk.
Years ago, his stepdaughter went on a week-long spring season river rafting and camping trip organized by her high school. This was an annual trip. However, the previous winter had especially heavy snow fall and so the river was exceptionally high, and with fast rapids. Worse, the weather for that week was to feature more heavy snowfall and freezing temperatures.
Then disaster struck.
Within the first hour each of the rafts capsized in the river. Each student was in danger of suffering from hypothermia. Most of the food and medical supplies were lost to the river and thus were in extremely short supply. A student broke his leg. One of the instructors/guides essentially had a mental breakdown and was crying and quivering in the snow. The instructor in charge refused to call off the entire exercise and decided to persevere through the rest of the week. Consequently, several students had to be hospitalized, with half of them becoming critically ill, too.
Naturally, the parents were in an uproar with the school’s administration and demanded an explanation as to why they wantonly had endangered the kids. The response: “Our instructor is extremely experienced and led these expeditions for over a decade without incident.”
Jason points out to what was so very wrong with that answer.
The school administration engaged in an incorrect risk analysis of the instructor’s experience. The relevant experience for the situation was not how many years of expeditions he had led (wrong context). The relevant experience for the situation was how many expeditions he had led where everything went wrong, and from the very beginning (correct context). This is the correct and relevant experience.
It turned out that the instructor had never really come anywhere close to experiencing these difficulties in the past.
Context is key to risk perception and management.
Risk exists in every single aspect of our lives. It is a strange beast that means different things to different people. And that is why, when evaluating what the risk of a situation is or a particular asset allocation or an investment product, you need to view in a very specific context and how it fits in with your goal. You cannot efficiently evaluate risks if you are unaware of your goal.
Kat Cole, the COO of Focus Brands, had a chaotic childhood. Her father was an alcoholic and her mother had to work multiple jobs and kept the family on a $10-a-week food budget. Kat, just nine at that time, had to shoulder a fair amount of responsibility as she had two younger sisters.
When Cole was studying at the University of North Florida, she worked as a waitress at Hooters. She excelled and was named the franchise’s best employee. They requested her to go to Australia to train employees at a new franchise. At that time, she was not in possession of a passport and had never stepped on a plane before. She grabbed the opportunity.
Her studies began to get severely affected. She had no powerful and connected friends. Nor did she have an affluent family to fall back on. She wasn’t going to Silicon Valley, where dropping out of college is considered by some to be a bad of honour. (Think Bill Gates and Mark Zuckerberg). In her world, college was the surest path to success and stability. So when she decided that she would drop out of college for the job, it appeared like a very risky call that could backfire with disastrous results.
The gamble paid off. Big time. She was offered a salaried job at the corporate headquarters and became an executive vice-president by the time she was 26. At the age of 32, she was hired by Cinnabon.
For most individuals, dropping out of college would be risky, for Kat Cole it was not risky because at such a young age she had a job she loved and was appreciated for. It seemed a better option to stick on and work her way to an executive job rather than accumulate college debt.
Risk is different for everyone because it depends on the individual’s goal.
Taking a risk without a goal is just like getting in a car and driving around aimlessly expecting to wind up in a great place. If you have a destination in mind, you are much more likely to end up there.
What was Kat’s goal? To get a good job and achieve the security and stability she lacked as a child. Now she was being presented with a way to get what she ultimately wanted, even if it was not on the terms most people would be comfortable with. She explains in the book An Economist Walks Into A Brothel, “It was not that difficult a decision because I had a compelling alternative. I was travelling around the world. I was doing something I loved. I was good at it. I had an opportunity to keep doing it.”
Risk: What is it really?
More on Behavioural Finance
Articles by Investment Specialist Larissa Fernand