MiB: Danny Kahneman on Noise

 

This week, we speak with Danny Kahneman, winner of the 2002 Nobel Memorial Prize in Economic Sciences. His empirical findings with Amos Tversky challenge the assumption of human rationality prevailing in modern economic theory, and established a cognitive basis for common human errors. He is a professor emeritus of psychology and public affairs at Princeton University and a fellow of the Center for Rationality at the Hebrew University of Jerusalem.   His book, Thinking, Fast and Slow was a best-seller; His new book is Noise: A flaw in human judgment cowritten with Oliver Sibony and Cass Sunstein.

Kahneman explains why the assumption that noisy errors tend to cancel out is incorrect; instead, they tend to add up. Two mistake don’t average out to a good decision, they add up to two bad choices.

He describes “Noise” as an interference in judgement, especially in institutional decision-making. Consulting for an insurance company, he was surprised to learn how widely the differences were between expectations for underwriting  and policy payouts variability was 10%, but the actual range was ~55%. That 5X increase in noise was a source of error, expensive across different fields but surprisingly common. Noise can cost a single large company $100s of millions or even billions of dollars over time. The industry costs are potentially staggering.

Some fields have strong feedback loops, and these industries tend to identify and manage noise — Aviation being the classic example. Other industries consciously ignore it. As an example, we discuss how admissions committees used to do blind reviews of applicants, with committees getting together and arguing for and against candidates. But most admission committees changed this approach — the first person reviewing a candidate scores them and they pass it on to the next person on the committee. This obviously biases/anchors and 9arguably) worsens the outcomes, but it also reduces arguments within the committee.

A list of his favorite books is here; A transcript of our conversation is available here Monday.

You can stream and download our full conversation, including the podcast extras on iTunes, Spotify, Stitcher, Google, Bloomberg, and Acast. All of our earlier podcasts on your favorite pod hosts can be found here.

Be sure to check out our Masters in Business next week with Scott Sperling, Co-Chief Executive Officer of private equity firm Thomas. H. Lee. The Co-CEO is a member of the firm’s Management and Investment committees. From 1974 to 2006, THL raised more than $22 billion in assets across 6 institutional private equity funds, completing more than 100 investments in excess of $125 billion of aggregate purchase price. Their flagship fund has more than $5B in it, and their Automation Fund has over $900 million in LP assets.

 

 

Daniel Kahneman’s Authored Books

Noise: A Flaw in Human Judgment by Daniel Kahneman, Olivier Sibony, Cass Sunstein

Thinking, Fast and Slow by Daniel Kahneman

 

Daniel Kahneman’s Favorite Books

Sapiens: A Brief History of Humankind by Yuval Noah Harari

Nudge by Richard Thaler and Cass Sunstein

 

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