The Effects of Risk on Your Wallet

We work hard at preparing for emergencies. We buy earthquake insurance if we live in an earthquake-prone area. We network on sites like LinkedIn even though we have a job.

Those kinds of actions are all efforts to reduce risks — visible risks. We want to be prepared for life’s curve balls, and preparing is one of the best ways to reduce the impact of would-be disasters.

But what about the risks we don’t see?

“People react to concrete and visible risks, not abstract ones.”

That quote from Nassim Nicholas Taleb’s book Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets points out something that most of us don’t give much thought to until it is too late.

We take actions to prevent things from happening that we can clearly see are risky. Those are risks that we can point to; risks that we feel are likely to happen. (Whether or not they really are.)

But we’re not so good at taking action to prevent things that are risky if we can’t clearly see and feel the risk. That failure to prepare can be costly.

Take the concept of a hundred year flood. Ask someone to define a hundred year flood, and chances are they’ll tell you that it’s a flood that occurs every one hundred years. If it’s flooded in their lifetime in the area, most people probably don’t think they need to worry about another flood happening within their lifetime.

But that’s not the case.

According to the U.S. Army Corps of Engineers, a hundred year flood “is in fact the level of water with a 1-percent chance (1 in 100) occurring any one year.” (emphasis mine).

So it’s possible to have hundred year floods within a very short period of time. (Just ask anyone who lived in Phoenix in the 70’s or early 80’s.)

But do you have flood insurance?

Would you wish you’d bought flood insurance if your neighborhood looked like this?

Generally speaking, risks have to feel at least a little bit urgent before we’ll act. Seeing a car floating in the street makes the risk of flooding both concrete and urgent, so we’re more likely to do things to minimize the risk.

This happens on smaller levels as well. Now I know that all hard drives fail. And I know I should backup my stuff regularly (and in fact I do use Mozy to automatically backup the most critical things each day) but…I’ve let a lot of stuff slide that should really be backed up too.

Yet it wasn’t until my computer bluescreened 3 times in a row that I suddenly took action and spent some time getting everything off my hard drive. I got lucky this time, but things could have turned out differently.

Whether or not we work to minimize risk, the risk of a hit to our wallet is still there. Don’t forget about the abstract risks that you don’t see regularly when making preparations.