In April 2021, Maxwell Meyer, editor of The Stanford Review, made a startling observation on the Stanford campus. He witnessed “…a student on a bicycle, wearing flip-flops, Air Pods in ear, going the wrong way through a roundabout in an active construction zone, with no helmet. But like any good follower of science, the student was wearing a disposable blue face mask…”

The observation prompted Meyer to conduct a follow-up study later that year.  During the busiest part of the day, he sat on campus and watched cyclists. Of the 400 bike bikers that pedaled past, 41% wore face masks while only 17% wore bicycle helmets.

Behavioral Finance

As Meyer’s study shows, we humans have a clear problem evaluating and managing risk. Why would twice as many cyclists wear face masks over helmets? How did they come to the inexplicable conclusion that Covid-19 posed a bigger health threat to them while riding outdoors on a 99% vaccinated campus, than the physical risks of riding without protective gear and ignoring traffic patterns?

This cognitive dissonance isn’t reserved for college students alone. From extended warranties to alien abduction insurance, humans have an obsession with the idea of eliminating risk. But as the Stanford cyclists demonstrate, we often misappropriate risk priorities. This irrational decision-making is the study of behavioral finance and is frequently displayed in biases such as “loss aversion” or “herd mentality.”

Responses To Risk

In reality, there are four appropriate responses to risk: acceptance, mitigation, transference or avoidance.

Acceptance

Several years ago, I had a client tell me that they weren’t going to draft a will because they weren’t ready to die yet. While unwilling to accept that death doesn’t await our readiness, this client was willing to accept the risk of leaving the division of her estate to others. Her decision-making demonstrates an emotional roadblock revealed by Nobel Prize-winning psychologist Daniel Kahneman. Kahneman discovered that we make financial decisions based 90% on emotion and only 10% on logic.

The biker that Meyer initially observed had accepted the risks of reckless riding, but how much time did he spend calculating those risks? Probably not much. Accepting risk, necessitates moving past emotions or herd mentality and evaluating both the severity of the risk and how it affects those important to us. Skipping the purchase of an extended warranty on household appliances is an appropriate risk to accept. Skydiving without insurance is not.

Mitigation

Once we’ve properly evaluated a risk, we can choose to go beyond mere acceptance with mitigation. For the Stanford cyclist, this would entail wearing a helmet, obeying traffic laws and putting his Air Pods away.  For investors, this is often accomplished by constructing a risk appropriate, diversified portfolio. Investment risk remains, but they’ve reduced their susceptibility to it.

Transference

Insurance is most often associated with the method of transferring risk. Having appropriate life, health or disability insurance, would have transferred some of the biker’s financial risk to an insurance company in the case of an accident.

Unfortunately, transferring risk to an insurance company is also frequently used as an “investment” strategy. A whopping 84% of investors prefer perceived “safety” over investment performance.  Knowing this emotional proclivity, insurance salespeople often steer individuals toward insurance products that masquerade as investments but offer poor growth potential at high costs.   

Avoidance

Finally, we can respond to risk by simply avoiding it. Had the bike rider merely stayed holed up in his dorm that April morning, he would have avoided the risks involved with biking altogether. Trying to avoid all possible risks won’t lead to a very fulfilling life. One risk you can avoid, though, is the emotion-driven pitfalls of behavioral finance by reviewing your investments and insurance needs with a financial advisor.

Jonathan is the founder of Evenkiehl, LLC, an independent, fee-only Registered Investment Advisor located in Lancaster, PA serving clients locally and across the US.