Would you pay for risk management? For most lay people, the answer is often “no.” There’s an assumption that, on a common sense level, we understand the right amount of risk we’re comfortable in taking. Among finance professionals and the wealthy, there’s also a sort of swaggering arrogance that goes with it: an assumption that, based on education or wealth, there’s “proof” they have a better grasp of risk. But in truth, our brains suck at processing risk, and here’s why:
A loan shark story
This is about a former acquaintance of mine, whom we’ll call YM. YM is in his mid-fifties today, and is one of the few people I know who have ever gone to jail, and been caned. But you wouldn’t guess it from this slim built, family man with two children, and whose off days are spent on volunteer labour at the local animal shelter.
Between his mid-20’s to mid-30’s, YM had made an absolute killing in car sales. This may be partly due to this background, as he was top of his class in mechanical engineering, as well as being from a family that owned a major car dealership (let’s just say it’s active in more than one city in Malaysia). YM was practically made for the job.
YM wasn’t just good at car sales, he also dabbled in FX and commodities trading, and the man was a modern-day Midas: everything he touched turned to gold. But like Midas, he was also cursed by his own greed.
One morning in ‘13, I got a text from YM asking if I could help with some of his outstanding affairs. My first reaction was “Oh my god, what is it, cancer?”
But the text reply was “Going to jail.”
Turns out YM had, for a period of about three years, been a loan shark. And I don’t mean the sort who runs around and vandalises HDB flats with paint; I mean he was at the top of the chain. The original financier. And while he wasn’t involved in the gritty part of the business, he had a partner who was.
Which leads to the question: why?
A business more successful than the actual loansharking venture
If YM were desperate from a collapsing business, too many deals, etc. it still wouldn’t excuse what he did; but he was fine at the time.
YM’s business, without factoring in his trading profits, was netting around $480,000 a year. I don’t know what he made from loansharking, or if it was more than this (I doubt it); but there was no reason for him to take such a gigantic risk, when his existing finances were in good shape.
The simple reason here would have been greed: an instinct to acquire more, even at the cost of destroying his career, reputation, and receiving caning; which, from what I’ve heard about Changi Prison, is bad enough to require a doctor on standby.
It’s the prospect theory in action
The prospect theory, in behavioural finance, shows that people evaluate potential losses and gains in reference to their current wealth. As that reference point changes (e.g., wealth increases or decreases), their risk appetite will start to change.
Consider, for instance, a young student who makes $1,000 a month in a part-time job. If faced with a fine of $500 for littering, said student will probably walk to the bin to throw things every time. 50% of the monthly salary lost is too much to handle.
Conversely, consider someone like YM, who made about $40,000 per month. The $1,000 fine is much less damaging, so he’s more likely to take a risk and throw his wrapper on the ground, even though the objective amount of the loss ($1,000) hasn’t changed.
If you view it through a more rational lens, YM’s action doesn’t make sense. Taking less than five minutes to walk to the nearest bin is definitely worth more than $1,000, but the risk-aversion doesn’t kick in at that level of income.
(This is also related to the way gains and losses get confused by the emotional part of our brains. We lose our sense of exact value as numbers go up. On a reflexive level, most people perceive the difference between $10 and $50 to be greater than the difference between $150,000 and $150,040, even though it’s still the same $40).
In short, your tendency to ignore risks, and be blindsided by it, go up as your wealth or income rise
And that’s a big lesson for single digit millionaires. Just because you’re better off now than you were before, don’t let your brain get tricked into doubling or tripling the amount of risk you take. You do need to take some risks to keep pace with inflation; but never so much that the risk could end up wiping out your accumulated gains.
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