By May 25, 2010 Read More →

Why We Make Bad Decisions – Errors in Odds and Errors in Value

Why We Make Bad Decisions - Errors in Odds and Errors in Value

“An expert is someone who has succeeded in making decisions and judgments simpler through knowing what to pay attention to and what to ignore.” — Edward de Bono

Would life be better if somebody could tell us the right thing to do at all possible times?

Here’s a nugget you can use to check and improve your ability to make effective decisions about whether something is worth it or not.  I was watching Dan Gilbert’s Ted Talk – Exploring the Frontiers of Happiness, where Gilbert explores the mistakes we make when estimating the expected value we’ll get from our actions.  According to Gilbert, we have a tool to help us do the right thing at all possible times, but the problem is we can’t use it effectively because we can’t estimate odds and we can’t estimate value.

Dan Gilbert – Exploring the Frontiers of Happiness
Here is the video:

 

Bernoulli’s Formula
Daniel Bernoulli gave us a formula for help us figure out the expected value of something.  The gist is this:

Expected Value = the product of two things (odds of gain) x (value of gain)

What this means is that if we can estimate and multiply the odds and the value of the gain, we would know exactly how we should behave.  In other words, if we can effectively estimate the odds of our success and if we can estimate the value of our gain or our success, then we can better estimate the value, and know whether it’s worth it.

To highlight this, Gilbert shares a simple example.  In a coin toss, if it comes up heads, you get $10.  Should you pay $4 to play?  Using Bernoulli’s formula, odds are 1/2 that the coin will come up heads, and the value of the gain is $10, so (1/2) x ($10) = $5.  Since it would cost you $4, then according to Bernoulli’s formula, it’s worth it in this case.

The problem is, in real life the examples aren’t so simple and we make mistakes when we estimate the odds and the value.

Two Errors We Make
We make two errors when making decisions:

  • 1.  the odds
  • 2.  the value

We overestimate or underestimate the odds of success and we overestimate or underestimate how much we will actually value the gain.

Errors in Odds
We overestimate or underestimate the odds that it will happen.  For example, when surveyed, people vastly overestimate how many people die from fireworks or tornadoes.  At the same time, they vastly underestimate how many people die from Asthma or drowning.  Why?  Because we base it on what we’re familiar with or can easily see in our mind, whether it’s from the media or our own experience.

Errors in Value
According to Gilbert, estimating odds is a piece of cake compared to estimating the value. We make a couple of mistakes here.  One mistake is that we compare the scenario to the past instead of the possibilities.  For example, if you lost your ticket on the way to the movies, you won’t buy another one because you already spend the $10.  On the other hand, if you lost $10 on the way to the movies, you would still spend another $10 to buy the ticket.  In both cases, you’re down $10.  In the first case, you compare it to the past where you only spent $10 on a ticket and buying another would make it feel like you’re spending $20.

Another mistake we make is when we compare at the time of purchase, but not our actual experience.  For example, at the music store, the stereo might sound better compared to another one.  When we play it at home though, we will never compare that experience again.  In another example, we might pick a wine based on prices compared to other extreme prices on the shelf, but when we’re home we’ll just be comparing the taste.

3 Ways to Make Better Decisions
You can turn this insight into action using some quick checks whenever you need to make a decision:

  1. Ask yourself how you can check or better assess the actual odds of success.
  2. Rather than compare to the past, compare to the possibilities and net results.
  3. Rather than comparing against the immediate options on the table, test the value against the actual experience.  (For example, A might look better than B in the show room, but B might be a better fit for your actual scenario.)

When I can’t easily verify the odds, one thing that helps me sometimes is just asking some questions.  For example, if a doctor or mechanic wants to go down a certain path, I’ll ask them how many they’ve dealt with before and what their success rate is.  There’s a big difference whether this is somebody’s first time or if they’ve seen this 100 times before.

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Photo by ralphrepo.

7 Comments on "Why We Make Bad Decisions – Errors in Odds and Errors in Value"

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  1. Patricia says:

    JD
    If I was this rational in my decision making I never would have gotten married, adopted a special needs child with huge problems, or moved my dying mother into my home to die….I have to say the value is totally in my heart and the odds are I will cost my husband money to assist me in my pursuits of the heart.
    My whole life I have tried to figure these things out to minimize the emotions that my choices make on others…but I have still caused a great deal of suffering by my actions/ and financial loss. Only once or twice in my lifetime, have I thought I did the wrong thing. I am still just one giant mistake :) !

    You keep trying guy! Maybe I can change my wanton ways?

  2. Farnoosh says:

    J.D., you made me think a lot as I read this – I like posts that challenge me, especially with some math – It’s great that you are articulating some of the statistics and removing some of the emotional ties to making decisions. Thanks! :)

  3. JD says:

    @ Patricia — For matters of the heart, you have to follow the heart. You’ve paved a path of wisdom and amazing memories, as you blog shows. For matters of finance, health, and other daily matters, simply keeping in mind that we make errors in odds and value can helps us avoid some common pitfalls. You’re always learning and growing and that’s part of the success journey, one day at a time.

    @ Farnoosh — Thank you. Dan is the man when it comes to re-thinking how we find happiness and choose our paths, a decision at a time. I find his videos insightful and entertaining. He’s a great source of insight to draw from and gives me lots to think about and share.

  4. Alik Levin says:

    Threat modeling for the masses ;)

  5. Marla says:

    Thanks for sharing this, JD. (I know it’s been a while since you posted this…) I love TED and I am fascinated with the decision-making process. Very interesting insight and entertaining delivery.

  6. JD says:

    @ Marla — TED is one of my favorite sources of goodness. It’s funny how a little insight can go such a long way, on multiple levels.