LESSON 16Risk Is in the Eye of the Beholder

In the standard economics textbooks, rational agents take risks only when the probability of a successful outcome exceeds a painful one. Of course, avoiding all risk—driving cars, playing sports, flying in planes, or living in cities, just to name a few everyday risky activities—would make for a dreary life. Uncertainty is one of the very few certain things in this world.

In fact, research shows that very smart people, including professional planners and decision makers, systematically underestimate risks all the time. As I noted earlier, the problem of optimism bias is so common among managers and entrepreneurs that the Nobel Prize winner Daniel Kahneman and his late partner Amos Tversky came up with a name for it: planning fallacy. “In its grip,” Kahneman writes, “they make decisions based on delusional optimism rather than on a rational weighting of gains, losses, and probabilities.”1

The psychologists are right in one sense. Entrepreneurs are not looking at risk accurately because their high levels of optimism let them underprice risk and move forward. It seems probable to me that this is genetically coded. Without optimism bias, ancient humans would not have risked their lives to hunt the woolly mammoths or bears that fed the tribe. High levels of somewhat unjustified optimism seem to be most prevalent in 20-to-30-year-old men.2, 3 Perhaps this is why they are more likely than others to choose—and claim to enjoy—jobs that are ...

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