Perceptions of risk

This morning I was flicking through the latest copy of my professional institution’s magazine, The Chemical Engineer, when I came across an interesting article by Paul Davies: Paul is heavily involved in risk management at Lloyd’s Register in London.

The focus of this article was the fact that risk is perceived differently by different people and he offered an equation for risk.

Risk = Consequence x Likelihood x Outrage ⁽¹⁾

In investment it’s the outrage element that represents market sentiment, and it can spell disaster or opportunity.

Ever wondered at the drop in value of a high growth company’s stock when they report hugely positive results, that are only slightly below expectations?

Equally, outrage underpins contrarian investing: nobody’s surprised when a dog of a company reports poor results, but what if they’re good?

It’s not rational to expect a business to sustain double digit rates forever, and unrelated changes in long term cycles can improve the cash flow statement. The likelihood of either event may be similar, and the consequences for both company’s operations relatively minor, but the outrage, or delight, factor leads to disproportionate perceptions of risk; and hence return.

I’d love investment to be a rational activity where we could trust in the efficient market. With millions of individual human beings involved the outrage factor isn’t going anywere soon, so the only option is to try and understand it.

Reference.

1. Davies, Paul (2009) “Risky business.” The Chemical Engineer, (Issue 812), pp. 28–29.