Don’t Look Back In Anger

September 11, 2017 7:31pm

When you are staring at a multiple choice question and you have no idea what the answer is and so you go with the “C” fallacy and you get it correct.  It makes you feel good.  How about on the math test where Miss Othmar makes you show your work?  You get 90% through and you make one mistake that leads to an incorrect answer.  You feel terrible.  Luck plays a bigger role in our lives than we realize.

What determines a good decision?  It’s the outcome, of course.  Is it possible this is a stupid decision even though it worked out well?

Past performance does not guarantee future results. The core of the illusion is that we believe we understand the past, which implies that the future also should be knowable.  We understand the past less than we believe we do.  It is that the language that the world is more knowable than it is.  It helps perpetuate a detrimental illusion.  The inability to reconstruct past beliefs will inevitably cause you to underestimate the extent to which you were surprised by past events.

This new IPO is the next Google. I knew Google was going to do well, but didn’t buy the IPO. I’m not going to make the same mistake again. The reality is that, at the time of its IPO, Google’s success was a lot less certain than it now seems. Investors seeking to replicate the success of Google with another stock may be setting themselves up for disappointment by not adequately accounting for the likelihood of less favorable outcomes. 

What most people don’t know is that a year after founding google, the owners were willing to sell their company for less than $1 million, but the buyer said the price was too high.  There were events before and certainly many successful decisions after but, that single luck incident makes it easier to underestimate the ways in which luck affected the outcome.

We are prone to blame decision makers for good decisions that worked out badly and give them too little credit for successful moves that appear obvious after the fact.  Suppose you were in this presentation with Richard Thaler.  In a meeting with 23 executives plus the CEO of a profitable company in the print media industry, this scenario was presented:

You were offered an investment opportunity for your division (each executive headed an independent division) that will yield one of to payoffs. After the investment is made, there is a 50% chance it will make a profit of $2 million, and a 50% chance it will lose $1 million. Thaler then asked by a show of hands who of the executives would take on this project. Of the twenty-three executives, only three said they would do it.

Then Thaler asked the CEO a question. If these projects were “independent” – that is, the success of one was unrelated to the success of another – how many of the projects would he want to undertake? His answer: all of them! By taking on twenty three projects, the firm expects to make $11.5 million (since each of them is worth an expected  half million), and a bit of mathematics reveals that the chance of losing any money overall is less than 5%.

Although hindsight and the outcome bias generally foster risk aversion they also bring undeserved rewards to irresponsible risk seekers.  Leaders who have been lucky are never punished for having taken too much risk.  Sensible people who doubted them are seen in hindsight as mediocre, timid, and weak.

Decision makers who expect to have their decisions scrutinized are driven to bureaucratic solutions and reluctance to take risk.  As malpractice litigation became more commonplace, physicians changed the way they practice medicine.  They ordered more tests, referred more cases to specialists, applied conventional treatments even when they were unlikely to help.  These decisions protected the physicians more than they benefited the patients, creating a potential conflict of interest.