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financial reserves,or"rainy day"funds,safeguard local range a statistical formula produces. GFOA recently had the governments against budget-straining risks like reces- chance to test this with a local government that was at risk sions or extreme events that demand a quick and for wildfires.The association asked the local fire department decisive public safety response.The perennial question local to estimate the magnitude of potential fires, and we com- governments have about reserves is how much is enough.Too pared its estimate to data on actual fires that had occurred little and you may be underprepared for the risks you face,but in the region.The range from the fire department was almost too much may mean you're overtaxing the public or failing to exactly 50 percent smaller than the range suggested by the make investments in needed infrastructure or services. data we had gathered. GFOA recommends maintaining general fund reserves Another persistent flaw in people's reasoning about risk is equal to two months of operating revenue—or, put another tending to over-rely on recent experiences because they are way, equal to 16.7 percent of annual revenue. However, this able to more easily recall them.The classic example is flood is just a rule of thumb, and each local government needs to insurance,which people buy after a flood occurs—but after decide the right amount for itself. For example, a smaller a few years, many of those people will have let their insur- local government that relies on sales taxes (which are often ance lapse, even though the underlying risk of a flood has vulnerable to economic downturns) and is at risk for experi- not changed at all. encing a number of potential natural It isn't just people's reasoning about disasters would need relatively more reserves than a larger government that GFOA recommends risk that impedes a proper s in of it. Common analyticalytical tan tools is reliant on property taxes(which are maintaining general fund may actually lead to worse decision- usually fairly stable,despite economic reserves equal to two months making about risk. Perhaps the best downturns) and is subject to fewer natural disasters. of operating revenge — example is the average,which summa- rizes an array of data into one conve- TRYING TO or, put another way, equal nient number. However, the average UNDERSTAND RISK to 16.7 percent of annual obscures the variation in the data. revenue Variation is a source of uncertainty, The way to decide the appropriate and understanding uncertainty is key amount for your local government is to understanding risk. to better understand your risks. Risk can be defined as the probability and magnitude of a loss, An old statistics joke illuminates the disaster,or other undesirable event.'To understand risks,you Potential of this "flaw of averages"'to mislead: "[n a room of need to quantify them. Peter Bernstein, author of Against the ten people, if one of those people is Bill Gates, the average Cods: The Remarkable Story of Risk, makes a good case for Person is a millionaire." It is technically true that adding up why we need to quantify risk: the wealth of all ten people and dividing the resulting figure by ten would yield an amount of more than $1 million, and "Without numbers, there are no odds and no probabilities; that is not a good description of the actual distribution of without odds and probabilities, the only way to deal wealth. Similarly, the "average" earthquake, flood, or wild- with risk is to appeal to the gods and the fates. Without fire doesn't describe the distribution of risk well because it numbers, risk is wholly a matter of gut." obscures the more extreme occurrences of these events — Most human beings are terrible judges of odds and prob- and the more extreme events,of course,are of great concern abilities, making gut feelings a terrible way to judge risk. For to a local government. example, researchers have found that people are generally overconfident in their ability to predict the future.This leads TRIPLE-A us to underestimate the range of possibilities we face. In How can a local government go about getting a better fact, research has shown that human judgment generates a understanding of the risk it carries and the size of reserve it 50 percent smaller range of possibilities, compared to the should have? In its work with local governments, GFOA uses June 2019 1 Government Finance Review I I