Surprises really
shouldn’t surprise us
Damian Handzy says it is about time
EXECUTIVE SUMMARYEXECUTIVE SUMMARY
economic theory teamed up with
• Improbable events are far more common than
most people give them credit for
behavioural science and that investors
• Our brains are not shaped to understand
woke up to the fact that ignoring the
things the way they really are, but rather, only
to interpret things in ways that generally tend
likelihood of shocks is risky and costly
to increase our chances of survival
• We are naturally risk-averse with gains and
naturally risk-taking with losses, which can
BY: DAMIAN HANDZY
lead to poor fi nancial decisions
A
fter reading an article on have profound implications for how we perceive and manage
fi nancial risk management in fi nancial risks.
which I wrote that In essence, our brains are not shaped to understand things the
improbable events occur way they really are, but rather, only to interpret things in ways
more frequently than we expect, a that generally tend to increase our chances of survival.
colleague of mine told me about Mon Evolutionary ‘superfl uous skills’, such as understanding small
Mome’s 100 to 1 victory in the Grand probabilities, did not make much of a diff erence in our ancestors’
National, and how the last horse to win fi ght for survival and therefore never developed in them nor in us.
with such long odds was Foinavon in But the modern environment is diff erent, and fi nancial survival
1967. A few weeks later, Mine Th at today does require an accurate assessment of the probabilities of
Bird, at 50 to 1, won the Kentucky such events, or at least it requires suppressing the urge to dismiss
Derby. Th e last time that race had such them as impossible.
an upset was in 1913 when Donerail
romped home at odds of 91 to 1. RATIONAL CHOICE
Both results startled racing fans, even Th e human brain interprets – and misinterprets – information in
though their frequencies are rather rather specifi c ways, and studies in cognitive science and human
consistent with their odds: after all, we evolution are helping us understand this much better. So-called
should expect a 100 to 1 victory about rational choice experiments have shown that humans have
once a century. built-in biases about price fairness and risk profi les (just to pick
So why is it that whenever an two examples) that seriously aff ect our ability to estimate fair
unlikely event occurs – whether it’s an value and true risk. Experiments on people from a variety of
upset victory or a natural disaster or a backgrounds and cultures playing the ‘ultimatum game’ (in which
market crash – most people express two non-communicating participants either divide £100 based on
complete surprise? Cognitive scientists, one participant’s split or they both walk away empty handed if the
studying this type of human behaviour, non-choosing participant vetoes the split) show that we humans
have come up with explanations that will give up fi nancial gain if we feel unfairly treated. Universally,
32 SUMMER 2009
32-3532-35 adaptive markets.indd 32adaptive markets.indd 32 1/6/091/6/09 11:56:0311:56:03Professional Investor Summer 09.34 34 4/6/09 15:40:58
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