Risk and Rationality

23 April 2014

The world is a risky place where all sorts of nasty things could happen.  So, how do we decide what to do when there are risks at every turn?

Luckily, there’s a widely accepted theory that tells me when it’s rational to take a risk. It says that a rational person is someone who maximizes  expected utility.  The basic idea is that an agent does something and, depending on circumstances, it may have several outcomes we can rationally assess.

For an example, suppose I’m considering a sky-dive -- that is, jumping out of a plane and parachuting to the ground. If the parachute doesn’t open, there’s a good chance I’ll die. So, when I jump, I’m taking a risk. 

I jump out of an airplane. That’s my act. One possible outcome is the parachute opens, I glide to earth, and have a great time. The other is that my parachute doesn’t open, and I plummet to the ground, and die.  Each outcome has a value. Floating to the ground, seeing things from that perspective, the whole experience, would be amazing. Falling and dying, of course, would be terrible.   And each outcome also has a probability. Let’s suppose that parachutes fail to open once in ten thousand times. The probability of the great outcome is 99.99 %.  The probability of the terrible outcome is .01 %  So, to get the expected utility of the act, we take the value of each outcome.  Let’s say the good outcome is worth 1000 points and the terrible one is worth a negative 100,000 points.  Then we multiply it by the probability of it being the outcome and then add them together, getting, by my rusty math 989.

Now suppose the value of not jumping is minus-25. Everyone will think I’m a wimp if I don't jump. So the expected utility of not jumping is minus-25, compared to plus-989 for jumping.   So, it’s rational for me to jump, and risk my life, rather than not jump, and risk derision.  At least, it is once I've put my self in a position to make this choice, by getting in a plane with a bunch of risk-loving friends.

Is that the whole story?  I learned this theory in graduate school, so it must be right.  However our guest has some doubts. 

Comments (17)


Harold G. Neuman's picture

Harold G. Neuman

Thursday, April 24, 2014 -- 5:00 PM

Well. Risk is what it is.

Well. Risk is what it is. There are entire entities devoted to such ideas as risk management---I am sure you are aware of this. As you may recall, I have noted the work of one N.N. Talib, or possibly, Taleb. In either case, the Lebanese genius spoke of  black swans and other improbabilities. Risk, appropriately or not, is big business. It forms the foundation of such human institutions as insurance. Which are, in one ancient sense, usury. But, that ancient sense is no longer contextual---it seems.
Wish you all well.
Neuman.

Fay's picture

Fay

Saturday, April 26, 2014 -- 5:00 PM

Please comment on a risky

Please comment on a risky business that we all share: Travel. Because there was one shoe bomber, America began a policy where millions of us have to take our shoes off to get on a plane. Are policies decided on an "N of 1" rational? I say not. Isn't a deeply irrational policy made by politicians with extensive educations and training in statistical analysis simply crazy? Are there other examples where because one event happens, it makes the decider alter their risk assessment irrationally?
Fay

mirugai's picture

mirugai

Saturday, April 26, 2014 -- 5:00 PM

RISK ANALYSIS

RISK ANALYSIS
1. A crucial problem with risk analysis that was not discussed on the show is: realistic self-knowledge.  We are all highly skilled at one thing only: what gives us pleasure.  But we are crucially unskilled at being objective about our skills and abilities, and, worse, we tend to ignore any objective assessment of our skills and abilities. If we think about it at all we base our assessment of our skills and abilities not on our past performances, but on our guess at the kind of person we want to be socially and/or egotistically, all in service of our pleasures.
2. What should be socially and politically imperative is that people be responsible for the consequences of their risky behavior. But this is not popular in our culture where a deterministic/non-responsibility societal view operates to the detriment of all except the risk-taker, but which is tantamount to a religious belief.
3. The greatest impact of the financial crisis of 2008 and following is the re-calibrating of risk assumptions and assessment in the valuation of assets.
4. By the way, something John said is wrong: the 5th jump is not automatically more risky than the first; every jump has different risks based on the circumstances and conditions of each.  To understand this, think about the actual risks of the person?s first jump, and the risks of the same person?s, say, 300th jump 30 years later, and all the changes that have taken place over that period.
mirugai

Harold G. Neuman's picture

Harold G. Neuman

Sunday, April 27, 2014 -- 5:00 PM

Or, stated differently, and

Or, stated differently, and in probabilistic terms: the likelihood of anything changes, moment to moment, and there is no mathematically sound way of determining which direction such change might take. To then paraphrase the Lebanese gentleman I have mentioned: his notion of the antifragile is, at least, comparatively consistent with the scientific notion of anti-matter. Of course, physics and philosophy are, uh, galaxies apart, hmmmm? Good to read your musings, TS. Glad to see you are still very much on your game.
Warmest,
Neuman.

Dabrain88's picture

Dabrain88

Tuesday, April 29, 2014 -- 5:00 PM

I believe that risk is

I believe that risk is necessary to grow. If we didn't take risks, life would be boring and dull. Risk is the whole adventure and purpose of life. Life would be to predicable and the same all around without risks. Though thiers a small chance that my parachute my not work and i may die, it was better to take the risk of death then to not live on the edge at all.
I think what you should do when risks happen is purely up to the individual . Its all about choice.If you play it safe, then your life is the same all around, If you take risks , then your living life to the fullest.
Their is a loophole to choosing a life full of risks. You can get yourself into alot of sticky situations and predicaments.
The most rational time to take a risk is if you know you have everything to to do that one thing. For example, If i want to go the the Caribbean for a vacation, i don't  jump straight into taking the vacation. I think about how many days i have off of work, the timing of me get to and back form the airport, hotel reservations, luxury money, what to pack , tour reservations. I don't just get the days off and do it. I make detailed arrangements. Only then is a risk of gong off to a foreign country rational. You make detailed arrangements.

MJA's picture

MJA

Wednesday, April 30, 2014 -- 5:00 PM

I use to tell people in the

I use to tell people in the gambling world that the best bet is not to bet at all.
You just can't lose,
 
=

Harold G. Neuman's picture

Harold G. Neuman

Wednesday, April 30, 2014 -- 5:00 PM

In reference to the comments

In reference to the comments regarding growth and risk, I am reminded of remarks made by the philosopher, Daniel Dennett. Dr. Dennett made one of the more obvious comments, more than once, when he said we must make mistakes---in order to learn. That simple Dennett tenet (sorry, but ,no, not really...) is so right for these times, yet, most humans have not realized its wisdom. Dennett has been attacked, ad nauseum, for his views over the years---yet, he thrives. Funny how jealousy and adversity breed success? My own simplistic notion of historionic effect appears to be gaining traction in the philosophic world. Simply stated, it posits that we ARE the totality of our circumstances. But, it is, sadly, more than rocket science. Everything involving human interaction and behavior is such.The sponsors of this blog know who I am and how to reach me---if they so wish.
Good night, all,
Neuman.

Tim Smith's picture

Tim Smith

Thursday, May 1, 2014 -- 5:00 PM

Inflation makes no bet a

Inflation makes no bet a losing one doesn't it?
In love as well - no risk - is loneliness.
Hank Williams Sr. said it best...
Poor ol' Kaw-Liga, he never got a kiss
Poor ol' Kaw-Liga, he don't know what he missed
Is it any wonder that his face is red
Kaw-Liga, that poor ol' wooden head
I disagree MJA

Tim Smith's picture

Tim Smith

Thursday, May 1, 2014 -- 5:00 PM

Taking your shoes off is not

Taking your shoes off is not irrational if it insures that there are no shoe bombs on your flight.  Do you think the risk is non existent?  Is the burden of taking your shoes off too great?  Risk management is not the same as risk taking.  To board a flight without taking your shoes off... that's what we are talking about here.  Is that the choice you want?  Fay... you are a risk taker.  What is your thought process that makes you want to  take this sort of risk?  

Tim Smith's picture

Tim Smith

Thursday, May 1, 2014 -- 5:00 PM

Taleb is saying risk is not

Taleb would say risk is not what it is (in the modern sense).  The fallacy of couching risk as a game when life is anything but that he says is the root of financial uncertainty.  Small differences make for big uncertainty.  The business of limiting risk is big (Hedge funds, Option markets, Derivatives and yes...usurious Insurance.)  Insurance especially is in the "no risk" business.  They never lose money and haven't since ancient times.   That at least we agree upon.
The actual taking of risk is for the most part small.  New business and tech comes from the small and medium size businesses for the most part.  This is the risk discussed in the show: Steve Wozniak in Job's garage, Larry Page and Sergei Brin in a similar garage... Ken Taylor and John Perry starting Philosophy Talk  :-) .  Regardless of how these risks turn out what makes people take them?  I think Nassim would say it is not a calculated risk based on expected utility.
Neuman... your points are dense it's hard to take them face up.  I don't think you are on board with Taleb if I'm reading you here.

Tim Smith's picture

Tim Smith

Thursday, May 1, 2014 -- 5:00 PM

I have no idea what you are

I have no idea what you are saying here - and I have read and do admire Nassim Taleb at least what I have read.  Anti-matter is not a notion, it is a very real and palpable noun.  Antifragile, on the other hand, is an adjective.  What are you saying?  Why are you making this comparison?

Tim Smith's picture

Tim Smith

Thursday, May 1, 2014 -- 5:00 PM

1. Realistic self-knowledge

1. Realistic self-knowledge is indeed a very deep point and one not made in the show.  Caitlin got into this in her roving piece with the sky jumper who loved the thrill of base jumping.  Taking that leap of faith is a commitment to being a committed person.  This deserves more thought.
2. What exactly would you do differently to promote responsibility in risk takers?  Risk taking in some contexts are actually retarded by society, and even punished.  Think of the young engineer who has a chronically sick child.  Does he take a chance on a new business venture or take a job at a large corporation with health insurance guaranteed. 
3. No comment.  The greatest impact to me was I bought a house at the height of the bubble.  Fortunately I sold one as well.
4. For whatever reason the base jumper's parachute did not open in Caitlin's intro piece - I'm sure the chute would not open in 100% of the jumps where the exact same circumstances are prescribed.  If you are saying that is never the case - never the same in every jump then I'm not sure I get your point.  The changes that take place jump to jump are exactly the cause of the risk in each jump. Let me think about this because I think I'm missing something here.

MJA's picture

MJA

Saturday, May 3, 2014 -- 5:00 PM

Well then lets play!

Well then lets play!
There are three shells on the table and a pea. I place the pea under one shell and slowly move them around the table shuffling their arrangement. For 1 million inflationary dollars, which shell is hiding the pea? =

Tim Smith's picture

Tim Smith

Saturday, May 3, 2014 -- 5:00 PM

Let's do it.

Let's do it.  
The one with the pea under it.
How'd I do?
But seriously ... I see your point.  Vegas odds are stacked.  If you factor in the entertainment, cheap food and inflation...eh...still stacked... but I think you could make an argument for limited gambling in the name of fun.
In life you don't know the actual odds for most all actions that you take day to day.  It sounds like you are a proponent of expected utility which pretty much tells you not to gamble.  Point taken there.  If you are happy where you are then there is no need to gamble at least.  Investing however is required to tread water.  Though some would say investing is gambling with your money it's not the same thing certainly.  In fact the majority of risk in life is not so clear cut as Vegas house odds.  Are you universally risk averse if you are happy in your current situation?  I think not in all cases at least.  There are no universal rules for why people do or don't take risk...even in Vegas.  Either way risk or not you can lose as well.  Which seems to require some risk taking in life.

MJA's picture

MJA

Saturday, May 3, 2014 -- 5:00 PM

you lost! The pea was in my

you lost! The pea was in my hand. =

Tim Smith's picture

Tim Smith

Saturday, May 3, 2014 -- 5:00 PM

What does that say about Risk

What does that say about Risk MJA?  Are you only willing to play/risk where the expected utility is stacked in your favor?  Can all risk be set to Vegas odds?  Is the metaphor of Vegas a metaphor for life and risk?  What is your shill?  This blog?  I too find truth and beauty in nature the final arbiter.  Along the way it's nice to think about philosophy.  Today it's all about risk.  What do you got?  Where is the pea now MJA? 

Guest's picture

Guest

Tuesday, August 16, 2016 -- 5:00 PM

Their is a loophole to

Their is a loophole to choosing a life full of risks. You can get yourself into alot of sticky situations and predicaments Escorts service in Manchester

 
 
 

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