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I hope by the time this blog goes out that the havoc caused by Hurricane Matthew will have begun to subside.  As I’m writing this, there are still hundreds of thousands without power and many looking for rescue from flood water as high as 5 feet. As some cities begin to clean up, others are still facing further damage from flooding rivers.

Given the magnitude of this storm, it’s actually astounding the damage and lives lost weren’t greater.  I think a lot of the credit for that goes to the meteorologists who mapped the storm’s path and the ongoing news coverage urging people to evacuate.  News outlets relentlessly insisted that people follow the direction of their local leaders to evacuate and not underestimate the impact of the storm ahead.

As someone who has never lived in a coastal area, I’ve always wondered why people need so much encouragement to leave at-risk locations.  We see people stranded on rooftops and I must admit I have thought to myself “Why didn’t they get out of there?  They had plenty of warning.”  What I’ve come to recognize is that this is just an example that illustrates how truly difficult it is for human beings to assess risk.

Our brains assess risk innumerable times a day.  Should I stop or drive through that yellow light?  What’s the harm in eating this doughnut? Should I let my child play football? We’d like to think that each of the decisions we make is the result of a careful analysis of the costs and benefits.  What we know is that our decisions frequently depart from what is rational.  First of all, we just don’t have the time and wherewithal to sit and calculate statistic probabilities for every choice we make.  Secondly, our decisions are impacted by all sorts of other influences like our mood, our past, our environment, what we listen to and watch, what we like and don’t like and who we spend time with.  At a certain point, these decisions ultimately come down to trusting our gut.

The thing about our gut is that it sometimes has a blind spot for risk.  It’s not that we’re trying to be risky; we just downplay the negatives and end up thinking we’re safer than we are.  “Those storms never turn out as bad as they say.” Call it being overly optimistic or having the illusion of control.  Whatever it is, we are all susceptible to such errors in thinking.

We are most susceptible to misreading risk and overestimating our own control when we have choices, have familiarity with a task, are engaged in competition or are actively involved in a situation.  For example, people who choose their lottery numbers typically spend more on tickets than those with numbers randomly assigned.  Studies show that people wager more on hands of cards that they shuffle and deal; involvement in the activity increases the sense that they will wind up with a winning hand.

We have blind spots for risk in all areas of our lives, and our finances are no exception.  Here are a few things that commonly give us a misplaced sense of comfort and control:

  • Trading portfolios ourselves. When we trade for ourselves, we feel more in control.  Increased confidence often leads to a corresponding increase in how often we buy or sell stocks.  What we don’t see is that more frequent trading means more frequent commission charges and often paying a higher tax rate on capital gains.  These additional costs decrease long-term returns.
  • Owning what we trust. When we work for a company, own a franchise or even buy a company’s products, we may think we have special knowledge or control over the company’s financial future.  We confuse familiarity with safety and may invest a significant portion of our money into that business.  What we don’t see is that putting so much money into one investment, no matter how safe it seems, increases the overall risk in our portfolios.
  • Overconfidence. It is common for investors to have achieved success in one or more areas of life.  We may have successful careers, be good parents, be well-regarded in our communities.  It’s natural for us to think the things that made us successful in one endeavor will also make us good investors.  What we don’t see is that the ability to shape outcomes in our personal or professional lives does not increase our ability to shape investment outcomes.
  • Sticking with what’s worked before. When an investment strategy has worked for someone we know, it can be exceedingly difficult to accept it may not work the same way for us.  Familiarity again masquerades as safety, distracting from potential risks.  A portfolio of CD’s might have been a reasonable retirement strategy in the 80’s when interest rates soared, but what we don’t see is that they no longer keep pace with inflation.  Dad might have seemed ultra-conservative living off the dividends of one blue chip stock, but what we don’t see is that he had a significant amount of concentration risk.

Taking risk is a part of life and it’s certainly a part of investing.  Our goal should not be to avoid risk, but to avoid the blind spots.  When decisions involve choice, familiarity, competition and active involvement, we’re more likely to feel in control and miss potential risks.  Simply recognizing when those conditions exist gives us the ability to assess the risk before taking it, to seek out contradictory opinions and examine the pros and cons objectively.  Let’s challenge ourselves to look for the risks when the sun is shining because once the storm comes it’s already too late.