The Hidden Danger of Being Risk-Averse

July 3, 2013 Editor 0

People are generally not all that happy about risk. As Nobel Prize-winning psychologist Daniel Kahneman has written, “For most people, the fear of losing $100 is more intense than the hope of gaining $150. [Amos Tversky and I] concluded from many such observations that ‘losses loom larger than gains’ and that people are loss averse.”

While the phenomenon of loss aversion has been well-documented, it’s worth noting that Kahneman himself refers to “most people” — not all — when describing its prevalence. According to 20 years of research conducted by Columbia University’s Tory Higgins, it might be more accurate to say that some of us are particularly risk-averse, not because we are neurotic, paranoid, or even lacking in self-confidence, but because we tend to see our goals as opportunities to maintain the status quo and keep things running smoothly. Higgins calls this a prevention focus, associated with a robust aversion to being wide-eyed and optimistic, making mistakes, and taking chances. The rest of us are promotion-focused, see our goals as opportunities to make progress and end up better off, and are not particularly averse to risky choices when they hold the potential for rich gains.

Studies from Columbia’s Motivation Science Center have shown that prevention-focused people work more slowly and deliberately, seek reliability over “coolness” or luxury in products, and prefer conservative investments to higher-yielding but less certain ones. Further research conducted by Harvard’s Francesca Gino and Joshua Margolis, indicates that prevention-focused people are more likely than the promotion-focused to behave ethically and honestly — not because they are more ethical per se, but because they fear that rule-breaking will land them in hot water.

They even drive differently. In one study, researchers at the University of Groningen in the Netherlands equipped customers of a Dutch insurance company with a GPS that was used to monitor their driving habits. The prevention-focused were, not surprisingly, less likely to speed than their promotion-focused fellow drivers. A second study showed that they also needed larger gaps between cars in order to feel comfortable merging.

So when people talk about the factors leading to the recent recession, and you hear a lot about excessive risk-taking (what Alan Greenspan famously called “irrational exuberance”), the prevention-focused would probably be last on your list of potential culprits. But you would be wrong.

That’s because everything I just told you about prevention-focused people is true when everything is running smoothly — when the status quo is acceptable. When the Devil you know is better than the one you don’t (a prevention-focused bit of wisdom if ever there was one.)

When the prevention-focused feel they are actually in danger of loss — and when they believe that a risky option is the only way to eliminate that loss — it’s a very different story.

For instance, in one study conducted by Abigail Scholer and her colleagues at Columbia, participants invested $5 in a particular stock. Half were subsequently told that the stock had lost value — not only the initial investment, but an additional $4. The other half were told that the stock had gained $4 in value. (These values were determined — they were told — by a computer simulation of real-world conditions). Then participants were given the option to invest again, this time with a choice: a 75% chance of gaining $6 and a 25% chance of losing $10 (the conservative option), or a 25% chance of gaining $20 and a 75% chance of losing $4 (the risker option). Note that while the odds were longer, only the riskier option could eliminate the loss of $9 for those currently at -$4. Note also that these were undergraduate students to whom the dollar amounts at stake were significant.

The promotion-focused chose the risky option roughly 50% of the time, regardless of whether their stock had gained or lost value. But the prevention-focused preferred the risky option only 38% of the time under gain and 75% of the time under loss. In other words, prevention-focused people generally prefer the conservative option when everything is going according to plan, but they will embrace risk when it’s their only shot at returning to status quo.

This suggests that “excessive exuberance” may be something of a misnomer. Certainly there are risk-loving traders on Wall Street, and some of the blame for the events that led to the recession lies with them. But much of it seems to lie with investment bankers — people who rarely strike anyone as “exuberant.” If anything, they appear to despise risk — so much so that they lobbied hard to create a system (i.e., “Too Big To Fail”) in which comparatively little risk (for them) existed.

These are the people who, counter-intuitively, will take the most dangerous risks under the right circumstances. One of the most famous risk-takers in recent memory is JP Morgan’s “London Whale,” Bruno Iksil, who doubled down on a losing bet rather than admit his losses, ultimately costing the bank over six billion. Evidence from the Senate hearings on the matter, in the form of recorded phone calls and emails, paints a picture of desperation rather than over-confidence. (Incidentally, Iksil was head of the Chief Investment Office, the purpose of which is to protect the bank by hedging some of its other riskier bets. This is no longer ironic, when understood from the vantage of prevention focus.)

This is why the only deterrent to reckless risk-taking is to make sure that reckless risks have real consequences for those who take them — to make sure, as Nassim Taleb has put it, that the players have “skin in the game.” These consequences have to be worse than those of the risks themselves, or they will not be effective. And frankly, they still may not deter a true risk-loving, thrill-seeking cowboy trader — but then again, they aren’t really the ones you need to look out for.

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Categories: HBR, Insights

Tags: averse, risk