Sometimes, Evolved Human Instinct Is Much Better Than Modern Economists
Or, why nine women cannot reproduce a child in one month
đ Hey there! My name is Abhishek. Welcome to a new edition of The Sunday Wisdom! This is the best way to learn new things with the least amount of effort.
Itâs a collection of weekly explorations and inquiries into many curiosities, such as business, human nature, society, and lifeâs big questions. My primary goal is to give you some new perspective to think about things.
Iâve borrowed the core idea behind todayâs essay from Rory Sutherland, and to be honest, itâs not a light read. Yikes! There are some (light) mathematical calculations that you might have to do in your head to fully appreciate the idea that Iâm trying to convey. This means, you might have to read this essay more than once. Donât say I didnât warn ya. đ
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Q: How does mathematical thinking apply to human behaviour?
A huge number of (theoretical) findings in economics are based on a logical-sounding-but-entirely-erroneous assumption about statistical mechanics.
One of the most popular assumption in decision-making is that, if you wish to know whether a bet is a good idea, you can simply imagine making it simultaneously a thousand times, add up the net winnings, and subtract the losses. If the overall outcome is positive, you should make that bet as many times as you can.
This means, a bet costing $5 which has a 50% chance of paying out $12 is a good bet. Half the time, you lose $5 and half the time, you win $7. You will win on average $1 every time you play, so you should play it a lot.
So, if a thousand people play the game just once, they will collectively end up with a net gain of $1,000. And if one person plays the game 1,000 times, he would expect to end up around $1,000 richer too â the parallel and series outcomes are the same.
Unfortunately this principle applies only under certain conditions, and real life is not one of them. It assumes that each gamble is independent of your past performance, but in real life, your ability to bet is dependent on the success of bets you have made in the past.
Today, letâs talk about fallacies. More precisely, letâs talk about logically-sounding mathematically-proven frameworks in decision-making that are completely wrong.
Unless you wish to lose all of your lifeâs savings on a bad bet (if you are the gambling type) or, if you are entrepreneurial, price services in such a way that makes users feel ripped off, just because you donât understand the difference between maths and psychology, donât skip this essay midway.
Letâs crack on!
Letâs try again, with a different kind of bet â one where you put in a $100 stake, and if you throw heads, your wealth increases by 50%, but if you throw tails it falls by 40%. How often would you want to toss the coin?
If you do the maths, you should say, âquite a lot.â
All you have to do to calculate the expectation value over 1,000 throws is imagine 1,000 people taking this bet once simultaneously, and average the outcome, like we did last time.
If, on average, the overall group is better off, it represents a positive expectation â which means you should definitely take the bet. In other words, you should bet all your money on that. But, apparently not! Reality doesnât work that way.
Letâs look at it once again. If a thousand people all took this bet once, starting with $100 each (meaning a total of $100,000), the net payout would be $105,000, a net 5% return.
But, if you look closer, you would also see that, out of the thousand people, 500 would end up with $150 and 500 people would end up with $60. Even though the average of the group is better overall, some individuals are better off than others.
Now, if you take this bet repeatedly, by far the most likely outcome is that you will end up completely broke. A million people all taking the bet repeatedly will collectively end up richer, but only because the richest 0.1 per cent will be multi-billionaires, and the great majority of the players will lose.
If you donât believe me, letâs imagine four people each toss the coin just twice. There are four possible outcomes: HH, HT, TH or TT, all of equal likelihood. So, for the sake of simplicity, letâs imagine that each of the four people starts with $100 and throws a different combination of heads and tails: HH, HT, TH, TT
The returns on these four combinations are: $225, $90, $90 and $36 for the four people respectively. Now, there are two ways of looking at this. One is to say, âWhat a fabulous return: the collective net wealth has grown over 10%, from $400 to $441, so all four people must be winning.â
But if you put it in mathematical language, an ensemble perspective is not the same as a time-series perspective.
The more realistic viewpoint is to say, âSure, the collective net worth is better, but most of individuals are now poorer than when they started, and one of them is seriously broke.â In fact, the person with $36 needs to throw three heads in a row just to recover their original stake. Very less likely!
This means you should not take the bet. It would kill you.
Now, the math is simple, but not obvious. And since we all arenât professional statisticians or economists, the distinction is very likely to have never occurred to us. The sad truth is that it seemed to have escaped the attention of most of the economics profession too.
Itâs a finding that has great implications for the behavioural sciences, because it suggests that many supposed biases which economists wish to correct may not be biases at all.
They may simply arise from the fact that a decision which seems irrational when viewed through an ensemble perspective is rational when viewed through the correct time-series perspective, which is how real life is actually lived.
What happens on average when a thousand people do something once is not a clue to what will happen when one person does something a thousand times. In other words, nine women cannot reproduce a child in one month.
Sometimes, evolved human instinct is much better at statistics than modern economists.
To explain this distinction using an extreme analogy, if you offered a hundred people $10M to play Russian roulette once, ten people might be interested, but no one would accept $100m to play ten times in a row.
Surprisingly, nearly all pricing models assume that ten people paying for something once is the same as one person paying for something ten times, but this is obviously not the case.
Ten people in a remote village who each order ten things every year from Amazon will probably not begrudge paying a few bucks for delivery each time, while one person who buys 100 things from Amazon every year is going to look at his annual expenditure on shipping and decide, âHmm, time to rediscover the local supermarket.â
At the airport, asking four businessmen to pay $25 each to check in one piece of additional luggage is not the same as asking a married father of two to pay $100 to check in his familyâs luggage.
While $25 might be a reasonable fee for the service, $100 is a rip-off. The way luggage pricing should work is something like this: $25 for one case, $35 for up to three.
There is, after all, a reason why commuters are offered season tickets â commuting is not commutative, so 100 people will pay more to make a journey once than one person will pay to make it 100 times.
Similarly, the reason policy makers should invest more in intra-city transport instead of inter-city transport is because 40 people saving an hour ten times a year (while travelling outside the city) is not the same as one commuter saving an hour 400 times a year while going to office every day.
The first is a convenience. The second is a life-changer.
Timeless Insight
Working 24/7 towards your goal with no personal life may sound good in a story with a happy ending. But it is a bad strategy in real life. Stories are written in retrospect. They distort our thinking.
Part of living a good life is finding a balance between saving and savouring. You have to wake up and work hard to save the world. But you have to take some time to savour it as well.
It is important to sleep, take rest, go out, and be with friends and family. 25 years from now, when you look back, you shouldnât see lack of sleep, all work, and no play. Instead, you should see a life well lived.
Work accordingly. Find some time for yourself.
What Iâm Reading
If your work is your self, when you cease to work, you cease to exist.
â Alex Soojung-Kim Pang, Rest
Tiny Thought
Your brain is most intelligent when you donât instruct it on what to do â something people who take showers discover on occasion.
Before You GoâŚ
Thanks so much for reading! Send me ideas, questions, reading recs. You can write to abhishek@coffeeandjunk.com, reply to this email, or use the comments.
Until next Sunday,
Abhishek đ