Embrace Your Inner Statistician!

You are a probability machine, a statistician, a mathematical wizard.

You may not be aware of this simple fact, but its true: Every day, you engage in a series of probabilistic decision-making. You choose based on the probabilities of various outcomes taking place. This occurs whether you are changing lanes on the highway or deciding what food to eat.

Consider some decisions many of you are likely to make over the next 24 hours:

• You will get in a car, and most of you will wear a seat belt (25% will not);

• For breakfast, some of you will have fruit and yogurt (or eggs and bacon);

• Lottery tickets will be purchased

• 2 million people will get on 87,000 flights on commercial airlines

• Money will be saved for retirement

• Homeowners will continue to have fire insurance.

• Casinos in Las Vegas, Monte Carlo and Macau will be visited by 100,000 people

• Several billion equity shares will be traded on the NYSE

Every one of the above actions are based on a probability analysis of a possible, probable and unlikely events occurring, and the resulting outcomes over time. We consider the facts we have, the things we do not know, and what information we might come to learn that applies to our next decision.

Us Humans have some problems with many of these elements. We tend to think we know much more than we actually do; we ignore the things we do not know or may not even be aware of; and when it comes to time, we over-emphasis immediate consequences and greatly discount future possibilities.

Consider the following:

Probability and Outcome Matrix Odds of Event Occurring Extremely Unlikely Probability Low Probability Medium Probability High Probability Extremely Likely Probability
Result if Event Occurs
Zero
Consequences
Sunrise tomorrow
Insignificant Minor Impact
Moderate but Significant Results Inflation? Insufficient Retirement $
Very Significant, Costly Results Hyper-Inflation? Market Crash
Total
Catastrophe
Fukushima meltdown Universal Entropy *

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When we see people debating decision-making, be it government policy or investments or what have you, it is often a probabilistic exercise. These disagreements are often actually a discussion as to which box to place the issue — what are the odds of occurrence? How negative are the consequences?

Now consider some of the flawed judgment calls we, as a species, makes. Our assessment of reality is at best, flawed, so we know less about the facts going into these probabilistic decisions than is ideal. We tend to be comfortable with high probablity, modest outcomes. We have trouble conceptualizing longer term outcomes. We have difficulty with low probability, catastrophic outcomes.

What statistical bets are you making today?

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* I am not sure about Universal Entropy, but I thought it was a good factor to stimulate thought.

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