The Personal Finance Index: Comprehending Risk
Personal finance knowledge is lowest in the area of comprehending risk. The following is one of the questions in the P-Fin Index survey related to this topic. The findings from this question highlight that risk is a difficult concept for most (approximately 60%) adults to grasp.
There’s a 50/50 chance that Malik’s car will need engine repairs within the next six months which would cost $1,000. At the same time there is a 10% chance that he will need to replace the air conditioning unit in his house, which would cost $4,000. Which poses the greater financial risk for Malik?
The car repair (correct answer; chosen by 41% of respondents)
The air conditioning replacement (chosen by 19% of respondents)
There is no way to tell in advance (chosen by 19% of respondents)
Don’t know (chosen by 20% of respondents)
Comprehending risk involves understanding that the expected financial outcome in a given scenario depends on the range of possible outcomes in the scenario, the financial implication associated with each outcome, and the likelihood of each outcome occurring. Proper financial decision-making should not ignore low probability outcomes based on the premise that they are not likely to happen. An outcome with a small likelihood of happening can still matter if its financial implication is very large. Likewise, outcomes with extremely large financial implications should not be overemphasized if they are very unlikely.