Risk Savvy: How to Make Good Decisions

by Gerd Gigerenzer

The breakneck speed of technological innovation will make risk literacy as indispensable in the twenty-first century as reading and writing were in previous centuries.

Without it, you jeopardize your health and money, or may be manipulated into unrealistic fears and hopes.

The Illusion of Certainty Nonetheless many of us ask for certainty from our bankers, our doctors, and our political leaders. What they deliver in response is the illusion of certainty, the belief that something is certain even when it isn’t.

When making decisions, the two sets of mental tools are required: RISK: If risks are known, good decisions require logic and statistical thinking. UNCERTAINTY: If some risks are unknown, good decisions also require intuition and smart rules of thumb. Most of the time, a combination of both is needed. Some things can be calculated, others not, and what can be calculated is often only a crude estimate. Figure 2-3. Certainty, risk, and uncertainty. In everyday language, we make a distinction between “certainty” and “risk,” but the terms “risk” and “uncertainty” are mostly used as synonyms. They aren’t. In a world of known risks, everything, including the probabilities, is known for certain. Here, statistical thinking and logic are sufficient to make good decisions. In an uncertain world, not everything is known, and one cannot calculate the best option. Here, good rules of thumb and intuition are also required.

The Three Faces of Probability One important fact is often overlooked. Probability is not one of a kind; it was born with three faces: frequency, physical design, and degrees of belief.10 And these have persisted to this day. Frequency. In the first of its identities, probability is about counting. Counting the number of days with rainfall or the number of hits a baseball player makes and dividing these by the total number of days or strikes results in probabilities that are relative frequencies. Their historical origins lie in seventeenth-century mortality tables, from which life insurances calculated probabilities of death.

Physical Design. Second, probability is about constructing. For example, if a die is constructed to be perfectly symmetrical, then the probability of rolling a six is one in six. You don’t have to count. Similarly, mechanical slot machines are physically designed to pay out, say, 80 percent of what people throw in, and electronic machines have software that determines the probabilities. Probabilities by design are called propensities. Historically, games of chance were the prototype for propensity. These risks are known because people crafted, not counted, them.

Degrees of Belief. Third, probability is about degrees of belief. A degree of belief can be based on anything from experience to personal impression. Historically, its origin is in eyewitness testimony in courts and, more spectacularly, in the Judeo-Christian lore of miracles.11 To this day, the testimony of two independent witnesses counts more than that of two who talked with each other beforehand, a...

Fix your gaze on the tower: If the tower rises in your windshield, you won’t make it. No estimation of the trajectory of the gliding plane is necessary. No time is wasted. And the rule is immune to calculation errors. In the words of copilot Jeffrey Skiles: “It’s not so much a mathematical calculation as visual, in that when you are flying in an airplane, things that—a point that you can’t reach will actually rise in your windshield. A point that you are going to overfly will descend in your

Every rule of thumb I am aware of can be used consciously and unconsciously. If it is used unconsciously, the resulting judgment is called intuitive. An intuition, or gut feeling, is a judgment: 1. that appears quickly in consciousness, 2. whose underlying reasons we are not fully aware of, yet 3. is strong enough to act upon.

To assume that intelligence is necessarily conscious and deliberate is a big error. Most parts of our brain are unconscious, and we would be doomed without the vast experience stored there. Calculated intelligence may do the job for known risks, but in the face of uncertainty, intuition is indispensable. Our society, however, often resists acknowledging intuition as a form of intelligence, while taking logical calculations at face value as intelligent.

Experts often search for less information than novices do, using heuristics instead. In the case of the US Airways pilots, they ignored all the information needed to calculate the trajectory of the sailing plane and relied on only one piece of information: the image of the tower in the windshield. The important point is that ignoring information can lead to better, faster, and safer decisions.

Given the many unknowns, few situations in life allow us to calculate risk precisely.

The illusion of certainty has two faces. Whenever known risks are mistaken for absolute certainty, the zero-risk illusion occurs (Figure 2-4, left arrow). Modern technologies that many of us believe to be all but infallible, such as HIV tests, genetic analyses, and imaging tests, provide high-tech vehicles for illusory certainty. The calculable risk illusion (or turkey illusion; see below) is different. It mistakes uncertainty for known risks. Like the zero-risk illusion, it is shown as a move to the left-hand side in Figure 2-4 (right arrow). In both cases, there is a clash between the real world and the perceived one. Let’s begin with risks that are mistaken for certainty. Figure 2-4. Two kinds of illusions of certainty. The first is to confuse a world of risk with one of certainty—the zero-risk illusion. The second is to confuse a world of uncertainty with one of known risk—the turkey illusion (calculable-risk illusion). In each case, the illusion corresponds to an arrow moving from the right side to the left.

The problem is improper risk measurement: methods that wrongly assume known risks in a world of uncertainty. Because these calculations generate precise numbers for an uncertain risk, they produce an illusory

Banks are sometimes criticized for operating like casinos. If only that were true! As Mervyn King, the former governor of the Bank of England, noted, if they did, it would at least be possible to calculate the risk. But investment banks play in the real, ever-changing, and uncertain world. Here, not everyone can be trusted, surprises happen, and trying to calculate precise risks can lead to disaster. In fact, the use of theories of finance designed for a world of known risks is suspected to be one of the causes of financial crises.

Some advice is considered so obvious that it cannot be but true. More information is always better. More calculation is always better. As we will see, this is a big mistake. In an uncertain world, complex decision making methods involving more information and calculation are often worse and can cause damage by invoking unwarranted certainty.

To make good decisions in an uncertain world, one has to ignore part of the information, which is exactly what rules of thumb do. Doing so can save time and effort and lead to better decisions.

Let’s sum up: 1. RISK ≠ UNCERTAINTY. The best decision under risk is not the best decision under uncertainty. 2. RULES OF THUMB ARE NOT DUMB. In an uncertain world, simple rules of thumb can lead to better decisions than fancy calculations. 3. LESS IS MORE. Complex problems do not always require complex solutions. Look for simple solutions first.

The checkerboard illusion illustrates that intelligence is not the ability to reproduce accurately every degree of light reflected from every square or every piece of information in general. It is the art of making informed guesses. Visual illusions help us to understand how our brains work: Our brains have insufficient information about the world. Intelligence means going beyond the information given and making informed bets on what’s outside. By making bets, every intelligent system makes “good” errors.

The visual system is not good at being a physical light meter, nor should it be. That’s not its purpose. It has to go beyond the information given and make bets about what’s out there. Making such “errors” is not a flaw; without them we wouldn’t recognize the objects around us. If a system does not make errors, it is not intelligent. Visual illusions in fact demonstrate the success rather than the failure of cognition.

Defensive decision making: A person or group ranks option A as the best for the situation, but chooses an inferior option B to protect itself in case something goes wrong.

Recognition heuristic: If you recognize the name of one company but not that of the other, then infer that the recognized company provides the better value.

To avoid blame, people hide behind “safe” procedures. Rely on big names, do what everyone else does, and don’t listen to your intuition. Put your faith in tests and fancy technology, even if these are useless or harmful.

In situations where errors have been deadly in human history, we have developed a tendency to avoid learning from experience. Instead, we rely on social learning of what to fear.

The best explanation can be found in what young people believe is important in life: in the distinction between internal and external goals.

People’s goals have shifted steadily since the end of World War II toward more and more extrinsic goals.

19 percent of Americans believe that they are in the top 1 percent income group. Another 20 percent believe that they will be there

In reality, upward mobility is no longer higher in the United States than in most other Western countries. Large parts of an optimistic American public support tax cuts for the rich from which they will never benefit.

the world of investment is largely an uncertain one, and relying on financial theories made for a world of known risk may lead to illusory certainty, what I call the turkey illusion.

Fear of personal responsibility creates a market for worthless products delivered by high-paid experts.

The essence of the theory is captured by an insight attributed to Albert Einstein: Make everything as simple as possible, but not simpler. How far we go in simplifying depends on three features. First, the more uncertainty, the more we should make it simple. The less uncertainty, the more complex it should be. The stock market is highly uncertain in the sense that it is extremely unpredictable. That speaks for a simple method like 1/N. Second, the more alternatives, the more we should simplify; the fewer, the more complex it can be. The reason is that complex methods need to estimate risk factors, and more alternatives mean that more factors need to be estimated, which leads to more estimation errors being made. In contrast, 1/N is not affected by more alternatives because it does not need to make estimates from past data. Finally, the more past data there are, the more beneficial for the complex methods.

In this way, one can begin to understand when less is more, and how much to simplify. High uncertainty Low uncertainty Many alternatives Few alternatives Small amount of data High amount of data Make it simple Make it complex

there is a simple cure to this ailment, although it requires courage to admit to ignorance: Don’t buy financial products you don’t understand. If Americans had used this rule, few would have lost huge parts of their retirement funds. If European bankers had relied on it, they would not have bought the junk, and the financial crisis would not have happened as it did. A top executive once explained to me how for years she was hesitant to admit when she did not understand an investment, for fear of looking stupid. Having learned her lesson, she has now found the courage to protect herself from “financial weapons of mass destruction.” When someone offers her an investment option, she responds: “You have fifteen minutes’ time to explain how it works. If I still don’t understand it, I won’t buy it.” A simple rule like that can reduce global spread of damage.

transparency helps create a safer world, while complexity can fuel potential disaster.

a “gut feeling,” or intuition, is a judgment (i) that appears quickly in consciousness, (ii) whose underlying reasons we are not fully aware of, yet (iii) is strong enough to act upon. Having a gut feeling means that one feels what one should do, without being able to explain why. We know more than we can tell.

An intuition is neither caprice nor a sixth sense but a form of unconscious intelligence. By definition, the person cannot know the reasons, and may invent some after the fact if you insist. To take intuition seriously means to respect the fact that it is a form of intelligence that a person cannot express in language. Don’t ask for reasons if someone with a good track record has a bad gut feeling.

What keeps executives from following their gut feelings? When asked, three reasons were mentioned again and again: 1. Rational justification is expected, intuition is not.

Group decision making conflicts with gut feelings.

3. The deep anxiety of not having considered all facts.

managers learn virtually nothing about intuition at their university. Instead, most are taught that there is only one rational way to make decisions, namely good-old decision theory. It asks them to do the impossible: to determine all possible alternatives, all possible consequences, estimate the utility of each consequence, multiply each utility by its probability, and choose the alternative with the highest expected utility.

In our society, intuition is suspicious. For that reason, managers typically hide their intuitions, or have even stopped listening to them. I have observed two ways to conceal or avoid gut decisions. 1. Produce reasons after the fact.

Defensive decision making. Here, the strategy is to abandon the best option because it cannot be justified if something goes wrong and to favor a second- or third-best option.

The rules are different for dealing with people and business strategy. People: First listen, then speak. If a person is not honest and trustworthy, the rest doesn’t matter. Encourage people to take risks and empower them to make decisions and take ownership. Strategy: Innovation drives success. You can’t play it safe and win. Analysis will not reduce uncertainty. When judging a plan, put as much stock in the people as in the plan.

True leadership means intuitively understanding what rule will work in what situation.

Common Misconceptions About Intuition 1. Intuition is the opposite of rationality. It’s not. Intuition is unconscious intelligence based on personal experience and smart rules of thumb. You need both intuition and reasoning to be rational. 2. Intuition is female. That has been the doctrine since the Enlightenment. Today, men are also allowed to have intuitions. The key difference is that men are still more hesitant to admit intuition or even listen to their gut. 3. Intuition is inferior to deliberate thinking. Deliberate thinking and logic is not generally better than intuition, or vice versa. Logic (or statistics) is best for dealing with known risks, while good intuitions and rules of thumb are indispensable in an uncertain world (Figure 2-3). 4. Intuition is based on complex unconscious weighing of all evidence. This thesis has been put forward to explain why intuitive decisions are often excellent. The idea is that if an intelligent process is good, it must function according to the bookkeeping method of weighting everything. But bookkeeping is only best in a world of known risk, not under uncertainty. There is strong evidence that intuitions are based on simple, smart rules that take into account only some of the available information. 7

The best action in the world of risk is not guaranteed to be the best in the real game show.

a useful guideline for how to win a competition: If you are highly proficient at a sport, don’t think too long about the next move. If you are a beginner, take your time in deciding what to do. And, if you want to play it mean: Make your expert opponents think rather than follow their gut.

The rationale is this: Expertise is a form of unconscious intelligence. The moment one succeeds in making the expert’s conscious thought intervene, performance is likely to decrease.

Learning to live with a good-enough choice and the possibility that there is something better out there is necessary in an uncertain world.

One class of rules of thumb is one-reason decision making: Find the most important reason and ignore the rest.