Cognition and Business Risk

This article (free reg. required) is awesome. It addresses a point that is becoming more and more evident all the time – we aren't always the rational beings we think we are. We make stupid mistakes because they just "seem right," like in the following example.

A bat and a ball cost $1.10 in total. The bat costs $1 more than the ball. How much does the ball cost?
Almost everyone feels the temptation to answer "10 cents" because the sum $1.10 so neatly separates into $1 and 10 cents, and 10 cents seems the right price for a ball (small and light) relative to a bat (big and heavy). In fact, more than half of a group of students at Princeton and at the University of Michigan gave precisely that answer — that wrong answer.

The ball costs a nickel. We make dumb decisions all the time because our minds evolved to help us survive, not accurately evalute financial risk. As a result, humans see patterns where there are none, and usually significantly misunderstand probability. That is why we make mistakes like the following.

In our first paper, Tversky and I did a study of the statistical thinking of professional statisticians when they're thinking informally. We found what we called the Law of Small Numbers, a term we coined in 1971 to describe how people exaggerate the degree to which the probability distribution in a small group will closely resemble the probability distribution in the overall population. And we also found that people, experienced statisticians, do not apply rules that they're aware of in guessing the probability of statistical outcomes.

And another example.

Yes, exactly right. Our innovation was that we identified some categories of risk that were the result of certain cognitive illusions. That was a novelty and that got people excited. But it's only part of the picture. There is an alternative way of looking at this that is becoming much more fashionable. There's a paper that I really like a lot. The title of it says the whole story: "Risk as Feeling." The idea is that the first thing that happens to you is you're afraid, and from your fear you feel risk. So the view of risk is becoming less cognitive.

S+B: So it's not that generalized emotion influences decision making. It's that one emotion — fear — distorts the perception of risk and introduces error into decision making.

KAHNEMAN: What actually happens with fear is that probability doesn't matter very much. That is, once I have raised the possibility that something terrible can happen to your child, even though the possibility is remote, you may find it very difficult to think of anything else.

S+B: It's like a Lorenzian imprinting of goslings: The phenomenon of fear imprints on a decision maker.

KAHNEMAN: Emotion becomes dominant. And emotion is dominated primarily by the possibility, by what might happen, and not so much by the probability. The more emotional the event is, the less sensible people are. So there is a big gap.

What does Kahneman think businesspeople should do with his research?

If I had one wish, it is to see organizations dedicating some effort to study their own decision processes and their own mistakes, and to keep track so as to learn from those mistakes. I think this isn't happening. I can see a lot of factors acting against the possibility of that happening. But if I had to pick one thing, that would be it.

Hell I could quote this whole article because I love stuff like this. Ever since an undergrad accounting class where we discussed sunk costs and how they were irrelevant to analysis, I've realized that humans make bad decisions sometimes because they just seem right. This is a very important article, well worth your time to register and read the whole thing. If it interests you, check out this old post, and this too, along with this very excellent book.

Via Brainwaves