Stephan Lods says analysing decisions that led to a 1977 airline disaster could help investors better understand risk 

Forty years ago, Captain Veldhuyzen van Zanten was probably the most distinguished pilot at KLM. He was the airline’s chief flying instructor and regarded as the company’s expert on Boeing 747 airliners. He was even featured front and centre in KLM’s advertising campaign touting their reliability. Nonetheless, on 27 March 1977 his decisions resulted in the deaths of 583 people. 

Ominously, KLM’s advertisement featuring van Zanten contained the headline: “KLM. From the people who made punctuality possible.” It was the concern about punctuality that probably led to his undoing on that fateful day. To begin with, the KLM flight was never meant to be in Tenerife. A minor terrorist attack at its Gran Canaria Airport destination had forced the flight from New York’s JFK airport to be diverted to the small airport in Tenerife. Other flights with the same destination had to do the same. 

Tenerife was not prepared for this kind of traffic and, to make matters worse, dense fog started accumulating. But maybe the biggest problem on van Zanten’s mind was the mandatory rest period for pilots. Being grounded for more than about five hours would have pushed him into the mandated rest period. Taking off after that would not simply have been a breach of airline policy, it would have been punishable with jail time in the Netherlands. 

So van Zanten and his crew on KLM flight 4805 were in a position of playing catch-up and started making decisions differently. Van Zanten decided to do an unscheduled refuelling to save time on the turnaround when he arrived late at Gran Canaria. But doing so meant that he missed a spontaneous opening to take off and fog engulfed the runway as they waited. 

When van Zanten got approval for his flight plan the fog was so thick that air traffic control could not even see his plane. The communications that followed were apparently confusing. There was some radio interference and both parties, the KLM crew and the Tenerife control tower, used some non-standard terms. Somehow after that, van Zanten decided to charge ahead down the foggy runway. Unbeknown to him, Pan Am Flight 1736 was parked halfway down the same runway.

By the time the two pilots saw each other, at less than 300 metres apart, it was too late. Van Zanten tried to pull up hard but the extra 40 tons of fuel he had just taken on weighed his plane down. Its tail dragged on the runway and the landing gear and engines ripped through the top of the Pan Am plane. His plane collapsed in a fireball about 150 metres down the runway, killing all 234 passengers and 14 crew members. The impact and fire on the Pan Am flight killed 326 of its passengers and nine of its crew. 

Stephan Lods

What was the effect of being in a position of playing catch-up? It injected undesirable emotions and motivations into the decision-making process. When we play catch-up we feel anger and irritation, we feel pressure, and we often feel oddly overconfident. Each of these emotions and beliefs leads us to taking more risk, risks that are often unwise and ill-considered. 

If van Zanten’s impatience played a role in the Tenerife disaster it was via risk perception as well as risk-taking. The emotions that impatience brings about, like anger, have been shown in research to cause us to perceive negative events as predictable, under human control, and the fault of others. That is, by being impatient or angry, we are not only more willing to take risks, we are also more likely to underestimate them and misattribute their cause. 

Following the terrorist attacks of 11 September 2001, US airline passenger traffic fell by as much as 20%. But Americans were not travelling less, they just opted to drive more. The risk of road accidents is not foreign or dreaded, and feels under our own control. On the other hand, the risk of death in an airline hijacking or terrorist attack is very foreign, out of our control, and was the subject of intense dread by every American following the attacks. But this was a mis-estimation of the true risks. 

German risk expert, Gerd Gigerenzer, estimated that an extra 1,595 Americans died in car accidents, just in the year following the 9/11 attacks, as a result of the decisions to drive instead of fly. 

Humans have the most advanced brain of any creature on the planet, but it evolved from a much simpler base. At the core of our brains is a structure called the limbic system, which we share with more primitive animals such as lizards and rodents. 

Overuse of our limbic system is responsible for ‘hyperbolic discounting’, a phenomenon in which people exhibit unnaturally high discount rates when making short-term decisions, and often unnaturally low discount rates when making long-term ones. To see hyperbolic discounting in action imagine someone offering you $10,000 in cash. Suppose that before taking the money you are asked what amount of money you would need to receive to be persuaded to take a cheque in two weeks instead of cash right now. Common answers of the person on the street are often an additional $100 to $1,000. 

Consider, alternatively, the offer to receive $10,000 on 15 April 2027. Before accepting, you are asked how much you would require to receive the funds on 30 April 2027 instead. In this case, the person on the street often expresses near indifference between these two dates, which are also two weeks apart, and is willing to take about $10,000 on either date, reflecting a near-zero interest rate. The mismatch between these two answers is hyperbolic discounting.

Neuroscientists find that when we make discounting choices about the more distant future, we disproportionately use the most ‘human’ parts of our brains such as the orbitofrontal cortex, located right behind our eyeballs. Alternatively, short-term and emotional decisions generate lots of amygdala activity – a central part of the limbic system, located above the back of the mouth. Neuropsychologists find that when people have more orbitofrontal cortex activity, they make more accurate judgments, they are more self-reflective, and they exhibit less overconfidence.

What is the moral of this story for our financial decision-making? First, we take too much risk. This is related to playing catch-up for several reasons. The nature of compounding returns is counterintuitive to many people. 

If you lose 20% on an investment, it is not 20% you have to make to get your money back – it is 25%. A 20% loss on a dollar leaves you with 80 cents. It takes a 25% gain on 80 cents to get to a dollar. This means that high-volatility investments are more likely to put us in the position of playing catch-up. 

The good news is that we do not have to fall victim to our biases. By adopting a slow-and-steady low-volatility investing strategy, we can prevent finding ourselves in a position of playing catch-up. We can also be more aware of the risks we are taking. Having information and acting with caution is what prevents plane crashes, and it is what makes for savvy and prudent investing. 

Our executive decision-making does not make us run from all risk. It does, however, make us aware of our risk-taking and, therefore, gather information – perform due diligence. When we think with our frontal cortex we think long-term. We think slow and steady. We think analytically. We do our research. In the long run, this will always be the way to win the race and act responsibly. 

Stephan Lods is founder and principal of Analytical Research which provides research, advice and assistance with portfolio construction to investors on hedge funds and hedge fund of funds