Focusing on the Extreme goes Against the Grain

It is very common that people just totally discount risks that are remote.

There is only a 1% chance of that happening so I am just not going to worry about it.

Is commonly how that might be expressed, or even suggesting that something remote is “never going to happen”.

Buying a lottery ticket is seen as simply playing.  Almost no one makes serious plans around the possibility of winning the lottery.  But many will dream.

Life insurance is an unattractive product in most of Europe and the interest in it wanes in the US, supported only by a large tax incentive.  Perhaps that is possibly due to the remote likelihood that is being insured against.  For most ages of working people the mortality rate is less than 1 in 1000.  A very remote event.

This is one way of thinking about risk tolerance.  If people (including the people who run companies) are not concerned about events with a 1/100 or 1/1000 likelihood, then the risk tolerance should be stated in terms of a likelihood that they are concerned about – say 1/20.  Then the risk tolerance can be the amount of loss that they can tolerate at the level of likelihood that they are willing to actively consider.

Part of the barrier to forming a risk tolerance statement may be the focus on the remote – on a remote level that is beyond the concerns of the people who are being asked to form this opinion.

Explore posts in the same categories: Enterprise Risk Management


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3 Comments on “Focusing on the Extreme goes Against the Grain”

  1. […] Focusing on the Extreme goes Against the Grain […]

  2. Per Stromsjo Says:

    I agree about the cognitive problem.

    Also, we need to account for the time factor. If an undesirable event has a 1/10 likelihood of occurring during any given year we’d have to multiply this according to our time perspective. Maybe not this year but the next one or the one after that…

  3. Eddie Says:

    I believe there is also a human cognitive problem with large numbers and small fractions. People understand 1 out of 3 more easily than 1 out of 1000. The human mind rarely encountered large quantities of tangible objects in the natural world. Hence, less evolutionary reason to be able to process large numbers.

    We’ve quite departed the natural world — for now.

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