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Popular Culture Review
Risk as Regret?
Risk has no one definition, but some theorists, notably Ron Dembo,
have defined quite general methods to assess risk as an expected after-the-fact
level of regret. Such methods have been uniquely successful in limiting interest
rate risk in financial markets. Financial markets are considered to be a proving
ground for general methods of risk assessment. However, these methods are also
hard to understand. The mathematical difficulties interfere with other social
goods such as disclosure, valuation, and transparency. In particular, it is often
difficult to tell if such financial instruments are “hedging” (decreasing
measurable risk by giving up certain windfall gains) or “gambling” (increasing
measurable risk and exposing the investor to catastrophic loss in pursuit of very
high windfalls that increase expected value). As regret measures rarely reflect
actual human risk-aversion, it is difficult to determine if the outcomes of such
transactions will be satisfactory. In financial markets one may need to measure
credit risk, information timing, as well as source risk, probability model risk,
and legal risk if there are regulatory or civil actions taken as a result of some
“investor’s regret.”
Tough Choices
Financial markets illustrate a more general problem in defining and
assessing risk: the ways that different types of risk combine. It can be hard to see
how the relative risks from different sources should affect one’s decisions. For
example, when treating a disease a doctor might have the choice of either using
a drug that had a high probability of causing minor side effects, or carrying out
an operation with a low probability of causing very severe damage.
According to the regret theory, the only way to resolve such dilemmas
might be to find out more about the patient’s life and ambitions. If, for instance,
the patient’s greatest desire centered on raising children, one might prefer the
drug even if it limited their mobility or physical capacity somewhat. However, if
the patient has already risked their own life several times in extreme sporting
events, the decision to do so one more time and recover fiill capacities may be
far pr