I put the garbage out yesterday and came back to my room quickly. I had been concentrating on an article, so I wanted to start drafting right away. Just before my fingers touched my keyboard, I started to doubt myself. Did I wash my hands after taking out the trash?

My gut said I did. How could I forget–I had taken out trash for so many years. It was a routine to wash my hands so I must have done it. I was sure even though I couldn’t remember the details of going to the washroom and applying soap. I am sure about many things I can’t exactly remember. I mean, I can’t instantly recall what I ate for dinner a week ago, but I am 100% sure that I ate a full meal.

I convinced myself that I had in fact washed my hands. In summary, my reasoning answered the following question:

Question 1: Given uncertain circumstances, what is the most likely explanation?

I reasoned it was more likely to forget to remember a routine action than to forget to do a routine action.

Then I realized I was being dumb. This entire discussion was meaningless from a risk management perspective. This is the relevant question:

Question 2: Given uncertain circumstances, what is the action you should take?

I’m no risk expert, but I’ve done well with personal decisions by understanding why question 2 is more important than question 1. The likely causes may inform our actions, but that should be a secondary consideration. Because of this thinking, I have been a better investor, a better lender, a better friend, and a better student. It’s not a natural way to think, but as I’ll argue below, I think it’s the proper way to make risky decisions.

I’m going to analyze question 2 using the economic idea of “states of the world.” This basic technique is used by professional stock investors, insurance companies, military leaders, and central banks with more precise math. But the thought process is illustrated even through my own trivial dilemma of hand-washing.

States of the world

I either had washed my hands (W), or I had not washed them (N). These were the two possible “states of the world” that I faced. I was unsure which one I occupied.

I reflexively tried to figure out which state I actually was in. The more I thought, the more I ruled it likely that I was in state W. This means I put a low chance I was in state N, maybe something like 1%, or 0.05%, or 0.01%. Lacking photographic evidence, I couldn’t rule out state N. But if I were a betting man, I would bet the house that I had washed my hands.

In essence, I had answered question 1 satisfactorily. I figured out what was more likely and went with it. But acting on that would leave me open to the biggest risk: I could possibly use my computer with dirty hands. It might be an improbable event, but it would have an undesired impact.

Instead of debating which state I was in, I should have thought of a question 2. What was I intending to do? The real goal was to minimize contamination of my computer keyboard. What is the proper action?

When I think like that, it becomes immensely clear that if in doubt, I should wash my hands again. The action would lead to the states of either washed twice (WW) or not-wash, then wash (NW). In either case, I would be sure that I washed my hand at least once to spare my keyboard.

Was it wasteful that I could possibly wash my hands two times? Yes. It would be a waste of time and effort. But that cost is trivial compared to the damage of contaminating my keyboard if I were actually in state N. That funk would have persisted since my keyboard is very rarely washed. How often do you wash your keyboard?

To phrase it differently, the cost of washing my hands possibly for a second time is an insurance against dirtying my computer.

Good decisions don’t depend only on outcomes

The above example illustrates this point. The rule “If in doubt, wash hands” occasionally causes me to wash my hands twice. But it always avoids contaminating my computer keyboard. The lesson: think more about question 2 than about question 1.

Sports announcers don’t get this point. They often second guess player’s or coach’s actions because “they didn’t win the game” or “they didn’t get the job done.” You should judge a decision on how it would do on average, in other possible situations. But sports writers usually document how winners make the right “gutsy” calls and losers somehow “miscalculated.” The same criticism applies to stock analysts who praise stocks that rise and criticize company moves that turn out bad, but were actually a good idea. This topic is juicy, so more on this in a future article.

Further reading

I read a lot of books, and enjoy them, but it’s not often I find the books life-changing. And that’s why I’m stunned at my most recent coincidence of reading two life-changing books (recommended to me by a loyal reader).

They are both written by Nassim Nicholas Taleb, an essayist and scholar who used to be a mathematical trader. The books deal with randomness and how to manage risk. One of the main themes is to look for the highest impact events, which are often unexpected.

The books criticize traditional risk management techniques in a very amusing way. Taleb illustrates over and over how popular risk management techniques blow up because their predictions are based on inappropriate risk models. Surprisingly, the books use very little math to illustrate technical concepts. These are books I am going to refer to over and over again. My only major criticism is the writing style which is a bit peculiar. It has since grown on me as I can attest that I enjoy the style upon re-reading passages.

I would also warn that these are very skeptical books that might raise more questions than answers. Know you’re in for a bumpy ride that might challenge the way you or your friends make a living. (I know this first-hand as he makes fun of economics frequently and even jabs at game theory in one example.) But hey, I didn’t say it was a feel-good life changing experience for me, just a life-changing one :)

The two books are Fooled by Randomness and The Black Swan. I like them so much that I’ve added a section to my sidebar called “Recommended Books” to point new readers to them.

I hope you find a copy of each and enjoy them as much as I have.

 

 

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