Following the schedule or our reading calendar
Here Kahneman studies how we combine expected probabilities of an event and how we value it in order to assign weights to different outcomes. That way, we assess how desirable it is for a person and what is its likelihood to happen.
Two main biases are presented here: the possibility effect and the certainty effect. The fact that we can change something from impossible to happen, to have certain probability to happen has a disproportionate effect on us. That’s the reason we buy lottery tickets: it rises a 0% probability to gain something to a very low probability. It is also the reason why we fear very small risks: the operation is quite safe, but there is a 1% risk that something bad happens.
In the certainty effect we know that something is going to happen, not that it has a 95% or a 99% to happen that it is going to happen for sure. This also has disproportionate effects on us.
So, Kahneman’s point here is that there is a relevant difference between the real probability of an outcome and how people calculate such probabilities. This clashes with Morgernstern and von Neumann theory of rational choice, that expects humans to be natural calculators of real mathematical probabilities.
To solve such a problem, within the prospect theory model, Kahneman and Tverksy proposed what is known as The Fourthfold pattern. Such schema predicts feeling and behavior of real humans considering the four combination of two variables: Probability (high or low) and expected value (gains or loses). In this model, emotions play a very substantial role, powered by risk aversion.
This chapter has the same problem we discussed when talking about Mr W. speciality or Linda the accountant. Yes, people have a different impression of risk and probability that the one that is taught in mathematics. So what? Consider the possibility effect: I am myopic and I need glasses. Surgery could solve that, but let’s say that there is a very small risk (less than %1) of losing my sight and becoming blind. I don’t care what a mathematician might say, I’m not going to take that risk, I prefer wearing glasses. If that makes me irational, so be it.
Kahneman is sympathetic with people like me, and admit that “The decisions described by the fourfold pattern are not obviously unreasonable” but says that in the long run, they are much costly.
The general discussion of gambling as a way to study how we make decisions, reminded me of Taleb and his critiques in Antifragile on how casinos are a very very bad model for studying risk. In real life, there is no way to ponder the probabilities of a certain event to happen, so at best, casino-based models are useless for any real risk assesment.