How does “Noise” affect decision making? According to Danny Kahneman, winner of the 2002 Nobel Memorial Prize in Economic Sciences, it manifests as an interference in judgement, especially in institutional decision-making.
We discuss the problem in his new book is Noise: A flaw in human judgment, cowritten with Oliver Sibony and Cass Sunstein.
Kahneman explains why industry often assumes noisy errors cancel each other out; what actually occurs is that these errors add up instead. Two mistakes don’t average out to a single median good decision, but rather, they accumulate into several two bad decisions.
As an example, he was surprised to learn how far off insurance executives’ estimates were for underwriting and appraisal variability. The execs thought the range among their employees might differ by as much as 10%, but in actuality it was 55%. That five times increase in was an expensive source of error – for a single large insurance company, it could add up to millions or even billions of dollars in lost opportunities and excess claims payments. The industry costs are potentially staggering.
Some fields have strong feedback loops, and industries like commercial aviation tend to identify and manage noise well. 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 many 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 arguably) worsens the outcomes, but it also reduces arguments within the committee.
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. THL has completed 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.