Guesstimating Probability

For whatever reason, there’s been a great deal of talk recently about some research done in the 1970s by Amos Tversky and Daniel Kahneman. It’s been discussed in Predictably Irrational and Nudge as well as in numerous articles/blog posts.

In short, what Kahneman and Tversky showed is that humans aren’t the best at making rational choices. For instance, Kahneman and Tversky were able to show several real-life instances in which people make blatantly irrational choices. (Such as cases in which people prefer A to B, prefer B to C, and prefer C to A–entirely irrational, but apparently common.)

How does this apply to investing?

One thing that they showed in their research is that people aren’t very good at estimating the probability of various outcomes. Unless we have actual statistical data in front of us, our brains use the following method for estimating the probability of an event: We ask ourselves “How easy it is to come up with real-world examples of such an event occurring?” The easier it is to come up with examples, the more probable we assume the event to be.

Unfortunately, this leads to 2 very strong biases:

• Recent events are much more fresh in our minds. As a result, we tend to assume that a reoccurance is far more likely than it really is.
• Dramatic events are impressed quite vividly upon our memories. As a result, it’s very easy to access those memories, making us therefore assume that such events are more probable than they really are.

What does this tell us about how we might respond to Recent Worldwide Financial Crises? Do you think it’s possible that people are ever-so-slightly overestimating the probability of such an event being repeated? 😉