Why Humans Misjudge Risk: Lessons for Business and Investment

By Serge Santos

Risk is a natural part of life, especially in business and investment. Yet, despite our best intentions, human beings still often get risk wrong in ways that can lead to financial devastation, business failures and missed opportunities.

Knowing these common errors can help business owners and investors make better decisions and could ultimately mean the difference between success and failure.

Below are some key reasons why humans misjudge risk and how you can avoid these costly mistakes.

1. The challenge of long-term thinking

Most people struggle with long-term thinking, and business owners are no exception, but focusing on immediate gains and short-term results often leads to poor financial planning and decision-making.

We only have to look at the wealthy industrialists and business moguls of the early 1900s. If their fortunes had been managed wisely, we should see around 16,000 multi-generational billionaires today.

Instead, much of that wealth disappeared due to overspending, bad investments and an inability to manage risk effectively over generations. This highlights the importance of sustainable financial planning and careful risk management to preserve wealth over the long haul.

Focus on long-term value creation. Prioritise financial discipline, strategic investment and succession planning beyond short-term profit cycles. By adopting measures like financial management beyond this quarter’s profits, disciplined investment approaches and succession planning, you don’t just protect what you built – you create a foundation strong enough to endure and grow across generations.

2. The illusion of control

We also tend to overestimate our ability to predict and control outcomes and therefore take excessive risks.

Many companies take on too much debt, assuming market conditions will always be favourable. Then, when there are unexpected economic downturns or changes in their industry, these businesses often collapse under the weight of their obligations.

The 2008 financial crisis is a bitter reminder of this, with banks and corporations leveraging themselves to unsustainable levels, only to face disastrous outcomes when market conditions changed.

Risk-taking should always be grounded on realistic assumptions rather than overconfidence. Stress-test your firm’s financial models, maintain enough cash reserves and avoid excessive leverage to cushion yourself from possible downturns.

3. The dangers of poor bet sizing

Confidence often outweighs calculation, leading people to bet large without properly assessing probabilities.

The ‘Kelly Criterion’ is a mathematical formula that helps determine the optimal size of a bet to maximise long-term return. Most, however, ignore this principle, and put too much money into high-risk, high-reward ventures rather than diversifying their portfolios. This typically results in tremendous losses when the bet doesn’t pay off.

Smart risk-taking is a balance between ambition and prudence. Diversification, position sizing and proper anticipation of financial bottlenecks must be kept central to your business and investment decision-making.

4. Chasing wins and ignoring probability

People also become fixated on huge potential gains while ignoring the statistical realities of their decisions.

Casinos manage to survive because gamblers underestimate the power of probability. Despite knowing that the house always has an edge, they continue to bet, thinking they can beat the odds. In business, this manifests as chasing high-reward opportunities without fully appreciating the risks involved.

Decision-makers must evaluate opportunities based on realistic probability assessments rather than wishful thinking. Using data-driven analysis and risk-adjusted return calculations will ultimately allow your business to make better decisions.

5. The reality of risk-taking

Humans think they can handle risk until they experience real losses, and many investors claim they are comfortable taking risks until the market is struck by a significant downturn.

The reality is, when faced with real financial troubles, emotions take over, prompting panic selling or financial catastrophe. The Mike Tyson quote, “Everyone has a plan until they get punched in the face,” perfectly captures this idea.

You must prepare for worst-case scenarios and ensure you can withstand volatility if losses materialise. Beyond standard mitigation tools like portfolio diversification, the discipline of scenario planning — and, crucially, the capacity to absorb the worst-case outcome — can help prevent emotionally driven decisions in times of crisis.

6. Underestimating “Black Swan” events

Rare, high-impact events are difficult to anticipate but can be devastating when they occur. The ongoing dismantling of the free trade-based economic order is a prime example — an unforeseen shift with far-reaching consequences that many failed to anticipate.

The global financial system collapsed in 2008 because banks and investors underestimated the probability of a large-scale economic downturn. Although the warning signs were there, most institutions failed to prepare for the possibility of a serious market disruption, leading to widespread financial devastation.

Companies and investors must be aware of the potential for “Black Swan” events – unpredictable but high-impact occurrences – and stay prepared. Maintaining liquidity, diversifying investments and having contingency plans can provide resilience in times of crisis.

Final thoughts

We all make errors of judgement in life, but taking a bad risk in business can have serious consequences, potentially jeopardising the future of your company.  

Understanding the common ways we, as humans, misjudge risk is crucial for making more informed decisions. In business, the difference between success and collapse often lies not in avoiding risk — but in understanding it. Master that, and you gain a genuine edge.