Risk Homeostasis

Risk homeostasis  is a theory on the evaluation of risk, developed by Queen's University (Ontario, not Belfast!) professor Gerald J.S. Wilde .  The basic idea is that when a way to reduce risk is introduced into a system, something inherent in human nature leads us to take greater risks in another area of that system.  


To illustrate the point, let's take a look at Wilde's now famous 1990s study of taxi-drivers in Munich, where  ABS (anti-lock braking system) was fitted to half of the cars within a fleet of taxis and at the end of the study, the crash rates of the two sets of taxis were compared. 

To briefly outline the impact of ABS, in June 1999, the National Highway Traffic Safety Adminstration (NHTSA) found that, on average, ABS increased stopping distances by 22% (on a gravel surface).  That 22% could be the difference between having an accident and escaping with a near miss, so you would think that the taxi drivers with ABS in their cars would have a lower crash rate but this wasn't to be the case. 



The crash rate remained the same for both sets of drivers, suggesting that because drivers knew they had better brakes, they could drive faster, tailgate other cars and rely on their brakes to get them out of trouble.  This is risk homeostasis - increasing the riskiness of your driving because risk is reduced in another area; in this case, by the braking system.



And if you think about it, we all do it!  Look out for it next time you're crossing the street.  If you're at a busy pedestrian crossing, odds are someone standing beside you will be texting a friend whilst listening to their i-pod.  They rely on the "green man" to get them across the road safely, paying no attention to the flow of traffic.  This is another example of risk homeostasis.  How often do you see someone cross the road at a place where there is no crossing, behaving in the same way?  If the same care and attention was displayed crossing the road in both instances, accidents at pedestrian crossings would be virtually non-existant but unfortunately, it isn't and they aren't.  In 2005 for example, the AA found that fatalities on pedestrian crossings accounted for 2.2% of total road fatalities in the UK.
http://www.theaa.com/public_affairs/reports/aa-pedestrian-crossings-survey-in-europe.pdf



I think that this result is an important one for the field of finance, particularly in wake of the 2008 financial crisis.  The development of the mortgage backed security (MBS) and the credit default swap (CDS) meant that financial institutions could hedge their risk through securitization.  But when the risk in this area was reduced, what happened?  The development of sub-prime mortgages; institutions lending money to people who were previously deemed too high-risk to be considered for mortgages, and the fuelling the property bubble in the US.

For a more detailed read on the Munich taxi-driver study and risk homeostasis  in general, I'll refer you to Malcolm Gladwell  once again!

Shopping for Jackets and Calculators

In 2002, Daniel Kahneman (a psychology professor at Princeton University) was awarded the Nobel prize for his work (with Amos Tversky) in behavioural economics.  Their work sparked the new discipline of prospect theory  - a theory that suggests that people do not always make the optimal decision when it comes to risk.




The following example is quoted in their journal article "The Framing of Decisions and the Psychology of Choice"  published in Science  in 1981:


Imagine that you are about to purchase a calculator for $15.  The salesman informs you that the calculator you wish to buy is on sale for $10 at another branch, located 20 minutes drive away.  Would you make the trip to the other store?


When Tversky and Kahneman posed this question, 68% of respondants said they would make the trip. 


The pair then rephrased the question:



Imagine that you are about to purchase a Jacket for $125. The salesman informs you that the jacket you wish to buy is on sale for $120 at another branch, located 20 minutes drive away. Would you make the trip to the other store?

Logically, this is the same problem as the calculator - a saving of $5 is there to be had.  But the results in this case showed that only 29% were willing to make the trip.





In the same paper it is noted that it is the percentage saving that customers tend to take into consideration:



"...the variability of the prices at which a given product is sold by different stores is roughly proportional to the mean price of that product."



and


"Individuals who face a decsion problem and have a definite preference (i) might have a different preference in a different framing of the same problem, (ii) are normally unaware of alternative frames and of their potential effects on the relative attractiveness of options, (iii) would wish their preferences to be independent of frame, but (iv) are often uncertain how to resolve detected inconsistencies."



What they are saying is that context  influences consumer behaviour.  If the same theory is applied to financial markets, we would surely see traders paying over the odds when the orders they place are of considerable size.  Or indeed, house buyers wrapping up negotiations early when they could have squeezed a saving of a couple of thousand dollars out of the deal.  Such behaviour would exacerbate the gap between asset price and intrinsic value, expanding the bubble.