Mar 23, 2011

Risk Aversion & Fallacy of Assured Benefits

"The quest for certainty blocks the search for meaning.
Uncertainty is the very condition to impel man to unfold his powers."
-Erich Fromm

A study on risk aversive attitudes of farmers in Tanzania (Rosenzweig and Binswanger 1993) shows the impact of choosing 'safer' crops: 20% lesser income.

Similar study on Ethiopian farmer's attitude towards using fertilizers shows the lengths people go to avoid risk, they could have produced 8% more, had they used fertilizers.

In a paper entitled Consumption Risk, Technology Adoption and Poverty Traps, authors (Stefan Dercon and Luc Christiaensen) conclude at one point, risk (avoidance) is  a cause of perpetuating poverty. It seems many folks would rather be stuck in poverty than risk using fertilizers, try new equipment or other, better crops with higher yields.

Now, let us not conclude that risk aversion is limited to farmers of Ethiopia and Tanzania.

Many savvy investors invest in debt instruments because they are considered more 'secure' than equity - despite long term data proving otherwise (Beating the Street - Peter Lynch).

Unit linked investments give sub-optimal returns yet, millions of dollars are poured into these instruments. Most insurance endowment plans in India don’t provide good returns (about 6-8 % CAGR) while well managed mutual funds manage to get 15% CAGR, almost double returns - that apparently doesn't bother a majority of people buying insurance and paying hefty premiums (they are actually contributing to the salary budget of inefficient insurance monoliths). Not surprisingly these traps (oops, schemes) don’t have favorable exit options, lest investors wake up and run away.

That is A LOT to pay for risk protection! Taking measured risks can make people (be it poor farmers or richer urban investors) richer - with far reaching consequences on economies.

Risk avoidance has little to do with education or sophistication (sophisticated urban folks are just more sophisticated in their risk aversion than peasants). Making optimal choices and avoiding poverty traps is actually to do with taking measured risks, making intelligent choices and avoiding comfortable yet sub-optimal choices.

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