Friday, September 30, 2011

Why people make bad decisions about rare events

 Daniel Kahnemann and Nassim Taleb discuss biases, the illusion of patterns as well es the perception of risk and denial

These guys are very good, and it is very surprising to me that they know each other well and talk all the time. The key points here are:

  • Rare events occur.
  • It is generally easier to model common events than rare events.
  • People have two predictive systems, an intuitive one and an analytic system.
  • People have limited rationality.
  • If you provide a simple model that works almost all of the time, and you don't have a model that predicts both the common and the rare events, then people will use the simple model.
  • The intuitive predictive system will tend to expect things to continue; thus you will intuitively feel that a simple model that has worked successfully many times in the past will continue to work.
  • (Apparently) your intuitive system feeling that the future will continue as the past will tend to overpower your analytic system which tells you that a rare event may occur.
  • If you build fragile systems, when the rare event does occur things will break.
This analysis explains why people live in beach communities subject to hurricanes, why Tokyo is built in a place where it may be destroyed by earthquake and typhoon, and why the financial system crashed in 2008.

Nobel Laureate Kahnemann made the point that it is wrong to assume that the firms are agents with independent will. The decisions made for firms are made by people in those firms. The incentives, risks and time frames of firm executives are not those of "the firm", its investors nor the general public. The financial meltdown was in part due to executives making decisions that paid off in terms of their own objectives and time frames but bankrupt their firms. Talib points out that the result was that a lot of these firms were capitalist while the simple predictions were paying off (and executives went home with big pay envelopes) but became socialist when the rare event of the financial crash occurred (and the state was asked to pay the costs).

While the context of this talk given two and a half years ago was the financial crisis, the deep structure applies to many situations. I very much like Talib's point that one should build structures and systems where possible so that rare events do not cause human catastrophes. Build earthquake resistant houses, hurricane resistant buildings, and bubble safe financial institutions.

The problem of course occurs in Haiti where day to day survival is so tough, where people are living in a continuing state of disaster, that you can't really expect them to move to places safe from earthquakes and tsunamis nor build safe houses rather than the shacks that they can barely afford.

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