Tuesday, June 15, 2010

Risk perspective

http://www.whartonmagazine.com/issues/815.php 

I saw this article about a game for understanding human behavior in the face of certain disaster. It was interesting to see what people thought especially in regard to hurricane risk.

The game is played such that you have a house, 20,000 in the bank earning 10 percent interest, and a guaranteed 3-5 earthquakes (either severe or mild)  before the game is finished. Let us assume that this is real life. I thought of two scenarios:
1. Let the house fail. Keep the money growing and just rebuild. (maximize cash to counter asset loss)
2. Fortify my house to a reasonable extent and increase the money. (minimize asset loss and cash loss)
3. Build and upgrade your house as much as possible. (maximize your asset)

The authors say that students who play this game opt for the money. This is a good risk from my perspective. The certainty is knowing that you will lose the house. So why invest in it when its a foregone conclusion you will suffer damage or total loss. This apparently makes you "lose" the game.

The "winning" idea is to rapidly upgrade your house to quickly deal with the certainty of a quake.

I happen to prefer the minimization technique though it is not clear at all if this strategy would pay off more than times than not.

The authors claim that the human mind fixates on short term gain rather than long term planning. The results appears counter-intuitive to me. The long term planning assigns the destruction as a certainty. It WILL happen. After all, what else would people do in a throw away economy? I understand why people would accept this as truth. This does not get at risk evaluation though. Risk is the lack of certainty on the potential destruction. Lack of Certainty. Potential destruction.

Once you include these factors things get more interesting. Rather than a severe or mild disaster, you need more of a distribution and a random one at that. Especially one that favors the shape of the true distribution (i.e. a long tail at the high end). Low probability of a strong quake. No guarantee of a quake. No potential threat assessment. Now do you protect your house minimally or increase your protection as time evolves given your interest rate?

Some argue that quakes and hurricanes are different. Hurricanes may have a few days warning and quakes happen without warning. Same to me given that interest accumulates on a different time scale.