Risk

Consumers often encounter uncertainty, particularly with significant purchases like education, homes, or cars, where decisions are often financed through loans. This uncertainty arises from various factors:

1. Uncertainty of Future Income

• Loans are typically repaid using future income, which is inherently unpredictable.
• Factors like job stability, economic conditions, or health can influence one’s ability to repay.
• Postponing purchases in hopes of greater income stability might lead to price increases (e.g., rising tuition fees, housing costs), further complicating decisions.

2. Quantifying Risk

To make informed choices, consumers attempt to measure and compare risks by assessing the likelihood of potential outcomes. This can be done through:

• Objective Probabilities: Derived from historical data, like housing market trends or average salary growth rates, providing a statistical basis for decisions.
• Subjective Probabilities: Based on individual judgment, such as confidence in one’s job prospects. Personal experiences and biases can make these estimates vary significantly between individuals.

3. Expected Value and Variability

• Expected Value: Probabilities are used to calculate a weighted average outcome, helping consumers estimate the most likely financial impact.
• Variability: Measured through variance and standard deviation, it indicates how much actual outcomes might deviate from the expected value. A high standard deviation implies greater risk.

4. Types of Uncertainty

• Risk (Known-Unknowns): Situations where probabilities of different outcomes are known. For example, the chance of defaulting on a loan based on credit history.
• Uncertainty (Unknown-Unknowns): Situations where probabilities cannot be determined, often involving ambiguity. For instance, the emergence of unforeseen expenses or economic crises.