In the book Risk Savvy, Gerd Gigerenzer explains the challenges we have with thinking statistically and how these difficulties can lead to poor decision-making. Humans have trouble holding lots of complex and conflicting information. We don’t do well with decisions involving risk and decisions where we cannot possibly know all the relevant information necessary for the best decision. We prefer to make decisions involving fewer variables, where we can have more certainty about our risks and about the potential outcomes. This leads to the substitution effect that Daniel Kahneman describes in his book Thinking Fast and Slow, where our minds substitute an easier question for the difficult question without us noticing.
Unfortunately, this can have bad outcomes for our decision-making. Gigerenzer writes, “few situations in life allow us to calculate risk precisely. In most cases, the risks involved are a mixture of more or less well known ones.” Most of our decisions that involve risk have a mixture of different risks. They are complex decisions with tiers and potential cascades of risk based on the decisions we make along the way. Few of our decisions involve just one risk independent of others that we can know with certainty.
If we consider investing for retirement we can see how complex decisions involving risk can be and how a mixture of risks is present across all the decisions we have to make. We can hoard money in a safe in our house where we reduce the risk of losing any of our money, but we risk being unable to have enough saved by the time we are ready to retire. We can invest our money, but have to make decisions regarding whether we will keep it in a bank account, invest it in the stock market, or look to other investment vehicles. Our bank is unlikely to lose much money, and is low risk, but is also unlikely to help us increase the value of our savings to have enough for retirement. Investing with a financial advisor takes on more risk, such as the risk that we are being scammed, the risk that the market tanks and our advisor made bad investments on our behalf, and the risk that we won’t have access to our money if we were to need it quickly in case of an emergency. What this shows is that even the most certain option for our money, protecting it in a secret safe at home, still contains additional risks for the future. The options that are likely to provide us with the greatest return on our savings, investing in the stock market, has a mixture of risks associated with each investment decision we make after the initial decision to invest. There is no way we can calculate and fully comprehend ever risk involved with such an investment decision.
Risk is complex, and we rarely deal with a single decision involving a single calculable risk at one time. Our brains are likely to flatten the decision by substituting more simple decisions, eliminating some of the risks from consideration and helping our mind focus on fewer variables at a time. Nevertheless, the complex mixture of risks doesn’t go away just because our brains pretend it isn’t there.