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Making decisions
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6.3 The psychology of risk

Within the psychological paradigm there is a different starting point for understanding risk. In financial economic accounts, risk is generally regarded as a combination of the expected magnitude of loss or gain and the variability of that expected outcome. Human perception of risk works rather differently. There are two other important components of risk that influence our perceptions: the fear factor – how much we dread the potential outcome – and the control factor – the extent to which we are in control of events. When risks combine both dread and lack of control, for example in a nuclear accident, they are perceived as very great. It is, for instance, common to fear an accident more as a car passenger than as a driver, even when we acknowledge the other driver to be the more competent.

While expected utility theory suggests people to be consistently risk averse, available evidence on human risk preferences suggests that we are risk averse when considering potential gains, but will often take significant risks to avoid losses. We are ‘loss averse’. Further, whether we see ourselves as operating in the domain of gains or losses depends crucially on how a decision is framed and the reference point we are using to judge losses and gains. For example, a manager considering ways of reducing an expected loss may have already mentally accepted the loss and hence may frame the problem as improving on the existing situation and hence incline to risk aversion. Or she may still, in her own mind, be striving to avoid the loss and hence inclined to take risks to avoid it.