It is not a smart play to hit on 19 in Blackjack or to draw to an inside straight in Poker because the odds are so heavily against winning. But people do it anyway and sometimes – very occasionally – they succeed.
We all like to think that we wouldn’t do that, and in extreme cases like those I mentioned above we rarely do. Unfortunately, all of us go against the odds far too often – in investing and in life. We all suffer from what is often called neglect of probability bias when making decisions under uncertainty. Note that we don’t misuse probabilities; we disregard them entirely.
The problem, as so often happens, lies in ourselves and with our cognitive biases. For example:
- Football coaches and teams “go for it” on fourth down far too seldom.
- Lots of people are afraid to fly while few are afraid to ride in a car even though flying is much safer.
- Many people keep loaded weapons for protection even though (a) it’s more likely that they will do something stupid by mistake than ward off a criminal, and (b) more people are struck by lightning than successfully shoot bad guys that are committing crimes.
- Lottery participants are (again) more likely to be struck by lightning than to win big.
Sadly, knowing the facts doesn’t necessarily help (as anyone who read Moneyball or saw the movie realizes). The typical response to the facts isn’t a refutation, it’s a story or anecdote about someone who defied the odds and won. For these people, a single, vivid example completely overrides statistics and probability.
Our brains do many things well. But calculating probabilities isn’t one of them. That flaw colors nearly every debate, argument and policy consideration.
In this experiment involving giving electric shocks to subjects, scientists found people were willing to pay up to $20 to avoid a 99 percent chance of a painful electric shock. On its face, that seems reasonable. However, those same subjects would also be willing to pay up to $7 to avoid a mere 1 percent chance of the same shock. It turned out that the subjects had only the vaguest concept of what the math means and represents. They were pretty much only thinking about the shock.
It’s no surprise that we’re bad at this, since the whole concept of measuring probability is a recent invention. As experts point out, when there is strong emotion tied to the unlikely event, our ability to continue to see it as unlikely goes out the window.
On the other hand, it is not irrational or unreasonable to protect against unlikely events when the consequences of the unlikely happenings are sufficiently disastrous. That’s the premise behind Nassim Taleb’s terrific book, The Black Swan. In those instances, our math skills aren’t any better, but we under-value the risk.
The bottom line here is that we tend to be lousy at analyzing probabilities. Therefore, since investing is so dependent upon probabilities and likelihoods under uncertainty (there are no sure-things), we’d be well advised to look at the math carefully and be sure we understand it fully before we make decisions and to make sure that our work is checked. Otherwise, chances are we’ll make mistakes and keep making mistakes. If we do, the probabilities say that our chances of ultimate success are greatly (and gravely) diminished.