Why Banks (and Regular People) Take Stupid Risks

A main concern of critics of the banking industry, from Occupy Wall Street protesters to government regulators, is how to rein in irresponsible risk-taking by banks. When risk is discussed in this context, it's seen as a bad thing, particularly by those who regard the late-2000s financial crisis as a failure of risk management. Over human evolutionary history, however, risky behavior has on balance paid off, which is why human nature is so risk-seeking in the first place. The question, then, is this: if evolution "wants" us to take risks, why does our risky behavior so often lead to disaster?

To answer this question, first consider how people are designed to take successful risks. Risky behavior evolves if those who take risks tend to acquire more resources than those who don't, and the more these resources benefit risk-takers' survival and reproduction, the greater risks they'll take. This explains why in humans and most other species, males tend to take more risks than females. Like many sex differences that evolve across species, this one stems from differences in obligatory parental investment [1]. Because men don't pay the costs of pregnancy and lactation, they could reproduce much faster than women could in ancestral environments (as I've tended to note often in this blog, e.g. here). Thus to a greater extent than women, men's reproductive success was limited by number of mates. A man with ten mates can vastly out-reproduce a woman with ten mates, so men had a greater incentive to compete fiercely with members of their own sex for access to mates (and particularly for the things that women find attractive, like status and resources).

For men in ancestral environments (and again, as I've noted repeatedly in this blog, e.g. here), the downside of this arrangement is that they're not only the biggest winners in the reproductive lottery, they're also the biggest losers; for every man with multiple mates, there are several who can't attract even one mate. In this respect, life is a higher-stakes game for men than for women, which gives men more of an incentive to take the risks needed to win big. So men, to a greater extent than women, are designed as risk-taking machines, and tend to be drawn to relatively risky pastimes (e.g. fist fighting, extreme sports) and professions (e.g. firefighting, investment banking).

One final point about successful risk-taking: it's not just about getting lucky. The best risk-takers are those who have some advantage—like a special talent, or a piece of information—that allows them to succeed where others fail. In this sense, the riskiness of their behavior is illusory, because their advantage makes it less of a gamble for them than it would be for others.

But enough about productive risk-taking. Why does risk-taking so often go wrong? There are three main reasons.

First, to be favored by evolution, a behavior must be adaptive not unfailingly, but merely on average. Imagine, for example, that a male is choosing between situations in which he has (1) a 100% chance of mating once, or (2) a 20% chance of mating ten times, and an 80% chance of not mating at all. He should choose the second situation, because although he'll fail four times out of five, his average reproductive payoff will be twice as high than it would be in the first situation (20% of ten is two). Evolution will favor risk-taking with a high failure rate, as long as it's adaptive on average.

Second, our risk-taking psychology can be led astray in modern environments. If this weren't true, Las Vegas would be just another rural outpost in the Nevada desert. Our minds evolved in environments in which resource availability followed discoverable patterns (such as game animal migration routes). In resource-rich environments—and casinos exaggerate their resource-richness, by trumpeting patrons' successes but not their losses—we enjoy taking the risks that would have allowed our evolutionary ancestors to discern these patterns. These patterns don't actually exist in casinos, but when we succeed in gambling, our minds are fooled into thinking that they do, and we continue to seek them.

Finally, when risk-taking goes wrong, it often happens at the systemic or group level, rather than at the individual level. Our risk-taking psychology evolved to prevent us from behaving maladaptively as individuals, rather than to protect us at any higher social level. Some behaviors that helped cause the credit crisis—such as betting that housing prices would rise indefinitely—were not perceived by individuals as being risky at all, because they conformed to what most everyone else was thinking and doing. Because they appealed to human herd instincts, these actions felt prudent to individuals, even though their consequences were ultimately devastating to national economies and to many segments of society.

Risk-taking will always be an important route to innovation and success, in investment banking and in many other human endeavors. But our risk-taking psychologies are fallible, particularly in modern societies, and knowledge of these limitations will improve our odds of success.

(A version of this article originally appeared in the author's "Natural Law" column in the banking magazine Global Custodian, Winter 2010 issue).

Reference

Trivers, R. L. (1972). Parental investment and sexual selection. In B. Campbell (Ed.), Sexual selection and the descent of man, 1871-1971 (pp. 136-179). Chicago, IL: Aldine.

Copyright Michael E. Price 2011. All rights reserved.