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It turns out that most of us are incredibly poor predictors about how we will respond to future risk. Because we don’t know the context of the particular risk in advance, this makes our error at forecasting the response virtually certain.
One morning a dozen or so years ago, my wife called me to say that our son had been in a seemingly serious car accident nearby. I told her I would swing by and pick her up so that we could go to the scene together. As I was about to pull up to her work, I called to let her know I was there. She said, “I’m at home, not at work.”
In all the rush, I took the mental shortcut of assuming where she was given the time of day without actually asking. It’s easy to do this when fear, and its first cousin risk, come into play. By the way, our son was fine other than a badly broken nose that had to be surgically repaired the next day.
Responding to the Unknown
Because most of us don’t have a lot of personal experience with things like car accidents, past behavior doesn’t provide much of an indicator for how we might react in the future. How we actually responded to stressful situations in the past gives us clues.
Life choices, including those with financial implications, are always made alongside our “best guess” about how this decision will work out and what our response might be if it doesn’t work out as planned.
An inch is always an inch. A foot is always a foot. Our feelings of confidence about life choices, however, aren’t nearly as easy to measure.
Future risks can’t be precisely measured in the present. We can’t be certain how we will respond because the depth and breadth of the risk are unknowable.
Evaluating and Managing Risk
The whole field of neuroeconomics or behavioral finance is dedicated to teasing out the differences between what we think our response to risk will be versus what the response really looks like.
Most of us think that we react rationally to risks but instincts overrule actionable information and facts. Preconceived emotions from previous experiences shape our perceptions and response to risk.
Our brains react based on what it thinks is about to happen. The ‘sticky wicket’ is it’s often difficult to change course and turn around if this response proves wrong.
Pay attention to how you react to fear and how you respond to risk. The trajectory of your financial life may be at stake. Start there.