Risk Policies

RISK POLICIES

Decision makers who are prone to narrow framing construct a preference every time they face a risky choice. They would do better by having a risk policy that they routinely apply whenever a relevant problem arises. Familiar examples of risk policies are “always take the highest possible deductible when purchasing insurance” and “never buy extended warranties.” A risk policy is a broad frame. In the insurance examples, you expect the occasional loss of the entire deductible, or the occasional failure of an uninsured product. The relevant issue is your ability to reduce or eliminate the pain of the occasional loss by the thought that the policy that left you exposed to it will almost certainly be financially advantageous over the long run.

A risk policy that aggregates decisions is analogous to the outside view of planning problems. The outside view shifts the focus from the specifics of the current situation to the statistics of outcomes in similar situations. The outside view is a broad frame for thinking about plans. A risk policy is a broad frame that embeds a particular risky choice in a set of similar choices.

The outside view and the risk policy are remedies against two distinct biases that affect many decisions: the exaggerated optimism of the planning fallacy and the exaggerated caution induced by loss aversion. The two biases oppose each other. Exaggerated optimism protects individuals and organizations from the paralyzing effects of loss aversion; loss aversion protects them from the follies of overconfident optimism. The upshot is rather comfortable for the decision maker. Optimists believe that the decisions they make are more prudent than they really are, and loss-averse decision makers correctly reject marginal propositions that they might otherwise accept. There is no guarantee, of course, that the biases cancel out in every situation. An organization that could eliminate both excessive optimism and excessive loss aversion should do so. The combination of the outside view with a risk policy should be the goal.

Richard Thaler tells of a discussion about decision making he had with the top managers of the 25 divisions of a large company. He asked them to consider a risky option in which, with equal probabilities, they could lose a large amount of the capital they controlled or earn double that amount. None of the executives was willing to take such a dangerous gamble. Thaler then turned to the CEO of the company, who was also present, and asked for his opinion. Without hesitation, the CEO answered, “I would like all of them to accept their risks.” In the context of that conversation, it was natural for the CEO to adopt a broad frame that encompassed all 25 bets. As with 100 coin tosses, aggregation could reduce the relative risk if the divisions’ outcomes were sufficiently independent. Shared exposures could limit that benefit.