Over 500,000 people visited Farnam Street last month to expand their knowledge and improve their thinking. Work smarter, not harder with our free weekly newsletter that's full of time-tested knowledge you can add to your mental toolbox.

Spillonomics: Underestimating Risk

Frequency and magnitude.

The people running BP did a dreadful job of estimating the true chances of events that seemed unlikely — and may even have been unlikely — but that would bring enormous costs.

… For all the criticism BP executives may deserve, they are far from the only people to struggle with such low-probability, high-cost events. Nearly everyone does. “These are precisely the kinds of events that are hard for us as humans to get our hands around and react to rationally,” Robert N. Stavins, an environmental economist at Harvard, says. We make two basic — and opposite — types of mistakes. When an event is difficult to imagine, we tend to underestimate its likelihood. This is the proverbial black swan. Most of the people running Deepwater Horizon probably never had a rig explode on them. So they assumed it would not happen, at least not to them.

Similarly, Ben Bernanke and Alan Greenspan liked to argue, not so long ago, that the national real estate market was not in a bubble because it had never been in one before. Wall Street traders took the same view and built mathematical models that did not allow for the possibility that house prices would decline. And many home buyers signed up for unaffordable mortgages, believing they could refinance or sell the house once its price rose. That’s what house prices did, it seemed.

On the other hand, when an unlikely event is all too easy to imagine, we often go in the opposite direction and overestimate the odds. After the 9/11 attacks, Americans canceled plane trips and took to the road. There were no terrorist attacks in this country in 2002, yet the additional driving apparently led to an increase in traffic fatalities.

When the stakes are high enough, it falls to government to help its citizens avoid these entirely human errors. The market, left to its own devices, often cannot do so. Yet in the case of Deepwater Horizon, government policy actually went the other way. It encouraged BP to underestimate the odds of a catastrophe.

Continue Reading