Risk is a concept not well understood by many people, particularly in a financial context. In this podcast we explore what it means in depth, why it is often a balancing factor for rewards, and how a better understanding of risk and reward can lead to better community outcomes.
We think of risk colloquially as the likelihood that something bad might happen, but the concept of risk is actually fairly neutral, at least in economics and finance. All it really refers to is how likely an outcome different from the expected outcome might occur, which could be positive or negative.
Generally in finance, we think of almost everything as a trade off between risk and reward, or more specifically trading off assuming higher risk and getting (on average) a higher reward versus assuming lower risk and getting (on average) a lower reward.
Unfortunately, humans are poor evaluators of risk. For example, we tend to overestimate the impact of big, concentrated events compared to slow moving problems, even if the latter are more impactful. We also sometimes ignore the normal fluctuations in any market but instead make linear projections of trends – this leads to phenomena such as speculative bubbles. Also, we often don’t guard against risk sufficiently because we think we’re insured. Lastly, we evaluate risk poorly because – as we’ve discussed in earlier podcasts – people tend to look at the risk of future happenings and compare them to the present situation, instead of the proper comparison of comparing the risks of competing future scenarios.
Many of the regulations we live with are responses to the societal harms caused by mispricing risk, such as FDIC deposit insurance and standards for financial disclosures by public companies.
The trouble with understanding risk is particularly applicable in the labor market – how we compensate employees. A compensation package is essentially a statement of a risk and reward tradeoff – generally private sector employees have more variable forms of compensation (which could include things like commissions and stock options) whereas public sector employees tend to have more stable (i.e., less risky) compensation plans. This also plays out in the types of pension plans offered, fueling misunderstanding particularly around public sector, defined benefit, pension plans. This pervades both the public and elected officials, who often don’t understand what an “unfunded pension liability” is or use it as a political cudgel. Also, many make erroneous comparisons when looking at public employee compensation packages versus private sector compensation packages.