You may have heard the term “risk attitude”. What does it really mean? In this article I will cover four known and studied types of risk attitudes.
Risk attitude is how you perceive risks. Do not confuse this with what your response to the risk is. I talked about risk response and how to deal with risks in other posts. Risk attitude is your underlying philosophy towards risk, whether personal or corporate. It may depend on your ability to face risks or the nature of the risks themselves and could impact your options and choices on how you want to deal with a specific risk or group or risks. It’s more like asking yourself “how much risk can I take?” Please let me elaborate and break this down.
There are four risk attitudes that are identified that I am going to talk about here. I will talk about them in simplified terms but will mention the theories that support them.
1. All or nothing. Go for the big prize. Say you’re on a quiz show and have already won $10,000. For your next question if you gave the correct answer you would double your money whereas if you got it wrong you would lose everything you’d won so far and be out of the game. You also have the choice to “pass” and just walk away with the $10,000 you’d won so far. In this risk attitude choice, also called the Hurwicz criterion, you’d go for the win and risk it all. That’s why it’s also called the maximax – maximum return and maximum risk.
2. Avoid risks like the plague. Under this attitude and taking the quiz show analogy you’d just collect your $10,000 and “pass” on the next question. No point in taking extreme risks if you could get away with something. This is also called the Wald criterion or maximin, where you are shooting for the maximum return you can get at the minimum risk you can get away with.
3. Give up as little as possible. We know that frequently when you have several choices usually no choice is perfect. With every choice there is something that you will give up. So you base your choice on what you are likely to give up the most if you had chosen something else. My teenage son was given a choice: go out with his parents for an all-you-can-eat buffet at a restaurant he really loves and a movie later on at home OR go out with his group of best friends, go to the movie theatre to watch the latest action movie and just have a sandwich on the run. If he chose to go with the parents he would be giving up time with his best friends and watching the action movie both of which he valued highly. So based on what he would be giving up, he chose to go out with this friends even though he really loved the buffet and his parents (I hope). This risk attitude is called the Savage or minimax criterion where you are choosing the action where you’re likely to lose the maximum given a minimum accepted return.
4. Flip a coin. So you are at a loss and don’t know whether you should make a decision on something because you have no idea how risky it is. You can compare it to something else. So let’s say that you are to decide whether you should invest your savings in company ABC or company XYZ. If you believe it is a 50/50 situation then just flip a coin and say if it is heads go with ABC and if it is tails go with XYZ. I say “believe it is a 50/50” situation because I am assuming you have no other way to measure the risk. Obviously in an investment situation I do realize there are ways to measure that risk. I am just presenting this for illustration.
What if you don’t think it is 50/50 and are not quite sure what the probabilities are?
Well in that case you could take another real world “iffy” situation, similar to flipping a coin, to compare with. Let’s say you are a soccer fan. What if you were given a choice between betting that Brazil beats Italy OR investing in ABC? Let’s assume that you are leaning towards Brazil. A quick lookup online shows the odds calculated for the next Brazil/Italy game. Let’s say that the odds are in Brazil’s favour and are 65% sure that Brazil would win. That means that you believe your likelihood of making money with ABC is at least above 65%.
This fourth way to approach risks is called the Laplace criterion and generally uses subjective probabilities.
Hope you found this simplification of the four risk attitudes useful.
Let me know what you think. Leave me a comment.