Money Mistakes To Avoid – Misunderstanding Risk

July 12, 2007

Fear and past experience are too often what drive our perception and preparation for risk. 

Past Experience
The article “Seven Money Mistakes to Avoid” in Smart Money magazine talks about “availability basis”, a term psychologists use to describe how people measure risk mentally.  We rely on images and emotions that come easily to mind when gauging how to prepare for this risk.  For example, if someone called to sell you flood insurance and you had just watched television footage of the New Orleans flood you may be likely to buy flood.  If on the other hand, it was the middle of August and hadn’t rained a drop in a month and a half you might turn them down.

Fear
While past experiences can cause us to underestimate risk, fear often causes us to overestimate the likelihood of an event.  The article uses the example of extended warranties to get the point across.  The likelihood of your electronics purchase failing in the near future is low but the fear of an $800 piece of equipment failing a year down the road is enough to cause many people to shell out for an extended warranty.

Probability
The article suggests we often ask ourselves what’s the best or worst that could happen, when in fact we should ask what’s likely to happen.  For example, the average person from 35 – 64 years old is six times more likely to miss an extended amount of work due to a bad  injury than they are to die.  However, more than two thirds of Americans have life insurance but fewer than one third have disability insurance. We’re spending all this money insuring our family against death when in fact we’re more likely to be without work because of injury.

How to Prepare for Risk?
There are people who spend years studying for advanced degrees on managing risk so we can’t expect ourselves to understand all the probability theory and statistical concepts associated with measuring risk. What we can do is not let fear get the better of us and not discount risks just based on our personal experience.

One good way to accomplish this is to ask friends, family, and co-workers questions about your concerns. This gives you a way to talk through the risks you’re trying to protect yourself against and will broaden your perspective on what the actual risks are and different ways to handle them. How do you manage financial risk in your life?

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Ben

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Ben
Ben Edwards, the founder of Money Smart Life, saved up enough to buy a Nintendo back when he was 12 years old. When he used the money to buy shares of Wal-Mart stock instead, he knew he wasn't like the other kids... His addiction to personal finance has paid off for his family and now he's helping you to afford the life that you want. Check him out on the web at Google Plus, Twitter and Facebook.

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Comments

4 Responses to Money Mistakes To Avoid – Misunderstanding Risk

  • Tomiko

    Hi there, i really impressed with your thought. Not only these we often makes mistakes and misunderstandings when it comes to money.

  • Andy

    The biggest mistakes people make when it comes to investing are overconfidence/optimism/illusion of control and fear of loss. Fear of loss is especially tough since it can make you sell a profitable investment too soon (fear of losing the profit) as well as make you hold on to a losing investment too long (fear of admitting your mistake and taking the loss — i.e., waiting to “get back to even”). Psychologists report that we feel the pain of a loss twice as intensely as we feel the pleasure of a gain.

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