Making Decisions in an Uncertain World

I'm a layam.
Hey, Betsy, can I have permission to maybe give away
twenty thousand dollars of our joint money in the interests
of something we really believe in, teaching economics.
I'm not really sure I like that idea, but I
do love teaching economics. So let me see where you're
going to go with this.
Great So, Naz, I've got a coin right here, and
here's an offer. If I flip pets, I'll give you
twenty thousand dollars. If I flip tails, then you have
to give me twenty thousand dollars. Do you want that deal?
Twenty thousand dollars is a lot of money for me
to lose.
Yeah, but you could also win twenty thousand dollars, and
the chances of you winning just as big as the
chances that you have to pay me twenty thousand.
Yeah, but it feels like a bit too big of
a risk. You know.
I'm with you, Nas, I mean, a twenty thousand dollars
bet makes me uneasy. It's a lot of risk, and
in this case, for no good reason.
Yeah.
We make decisions where there's risk and uncertainty every day.
Sometimes there are big decisions such as about your career,
like should you major in economics or chemistry or something else?
And sometimes there's smaller daily decisions like should you take
an umbrella to work today?
These are just some of the many decisions we have
to make which involve uncertainty, and decisions involving uncertainty is
our topic for this week's Think Like an Economist with
Me Betsy Stevenson.
And I'm Justin Wolvers. You're listening to the podcast which
teaches you the super tools of economics to turbo charge
your decision making, including those you're pretty uncertain about. Nestre
and Tabercoli Farres with us.
You know, I like to think I'm enter taking risks,
but justin your offer has made me reconsider that. So
I'm having a little bit of an identity crisis right now.
Well, nas, I don't want you to worry too much
right now. You see, the bet I offered you is
called a fair bet, a fair bet to gamble, which
on average will leave you with the same amount of
money If you play that game we'd me hundreds of times.
We'd both likely end up winning half the time losing
half the time, so would each end up with the
same amount of money that we had at the beginning,
but you and Betsy might have had a few heart
attacks along the way.
The point is that a fair bet takes what you
have and just adds risk to it.
Any risk that you face. We can boil it down
to two things, the probabilities and the payoffs. In the
bet I offered you, the probability you won twenty thousand
dollars was fifty percent, and the probability you lost was
fifty percent.
So it looks like the probability of winning and losing
counsel each other out.
So on average, you'd end up with no more money.
Trying to figure out how much more money you have
is something that economists have a specific term for. It's
called expected value, and expected value is how much you
can expect in dollar terms.
For all of the different outcomes. You add up the
probability of that outcome times its value.
In the case of the bet Justin offered you, Naz,
the expected value is zero. In other words, you could
lose twenty thousand with fifty percent chance and gain twenty
thousand with a fifty percent chance, So on average you
get nothing nothing but a lot of risk.
That is remember it what says, any risk would need
the probabilities and the payoffs. But here's the thing, the
payoffs you should think about. It's not just the dollar
amount the payoffs. You should really focus on how you
feel and how you'd experience each outcome. Now, as you
told me you didn't want to take my bit, even
though it was a fair bit.
Yeah, twenty thousand dollars is a lot of money for
me to lose. If I was going to lose twenty
thousand dollars, then I wouldn't be able to pay my
rent for the year, and there's a lot of other
really essential things that I just wouldn't be able to
buy anymore.
So this is a really important point about risk for
most people. If your consumption has to fall because you've
lost that amount of money, you're giving up really important
dollars that are necessary. The money you gain is less
valuable to you because maybe you're gonna be able to
spend that on things that are a little bit more
optional to your life style.
Economists use the term utility to describe your level of
well being. So when it comes to risk, instead of
thinking about the money you gain or lose, you want
to focus on your utility, because that's what really matters.
So you want to think about whether your average level
of well being or utility stands to rise if you
take this bit, or whether it'll fall.
So what we're trying to say is that the money
I could lose is going to be a really big
deal for my quality of life, but the money that
I might gain isn't necessarily going to ass that much
to my quality of life.
Now, as that's exactly right, we call this concept diminishing
marginal utility. So we just talked about the fact that
utility is how well off you are well marginal. Think
about the marginal principle. It's about how much extra utility
you're going to get from the next dollar you earn,
and diminishing says the more dollars you get, each additional
dollar gives you less and less additional utility.
In fact, research shows that on average, people have diminishing
marginal utility. You still enjoy each extra dollar, but you
enjoy it less than those earlier dollars that were vital
for keeping a roof over your head.
Say, now, to think about what this means for the
bet Justin offered you. You may not be able to
pay your rent if you lost twenty thousand dollars, But
if you gain twenty thousand dollars, you might just put
it into your savings or go out to eat.
More, and so diminishing marginal utility. Focusing on what happens
to your well being rather than your bank account explains
why we're risk averse.
It's another way of saying people dislike uncertainty. There's always
risk when you don't know the outcome of something with certainty.
So it sounds like you're saying that you're better off
avoiding fair bets.
I think that's right. A risk averse person doesn't accept
fair bets because a fair bet just takes that current
level of wealth and adds uncertainty to it.
We're talking a lot about risk, but we can't avoid
all risks either. I mean, we've got to take answers
in life if we want to live well. And there's
just so many examples of this. Applying for a job,
or telling someone our feelings about them, or studying for
exams that could really transform our lives. These are all
things that could not pan out, but if they do,
then they'll really add to our lives.
That's true, and we also got to accept some risks
with more mundane and everyday decisions. When you read out
at a restaurant, there's a risk you could get food poisoning.
Whenever you drink water, there's a risk it might be contaminated.
Of course, we want to minimize risks, but we don't
want to eliminate risks. We need to think about costs
and benefits so that we take risks only when they're
worth it, when that risk is going to leave us
better off.
That's why it's worth taking calculated risks, and that's when
you've assessed if the rewards of an outcomer bigger than
its risks. We call this the risk reward trade off,
and what it tells us is you're better off taking
a risk if it comes with a sufficiently higher reward
that it raises your average or expected utility.
This sounds like you're using the cost benefit principle. So
in other words, when you're looking at the risk reward
trade off, you should refuse a bet if the costs
are more than the benefits. And the costs and benefits
aren't just about money, they're also about your well.
Being exactly, And when you think about the risk reward
tradeoff in a fair bet, it's all risk and no reward.
Now we can find out how much you really dislike risk.
Justin offered you a bet head you win twenty thousand,
tails you lose twenty thousand. Well, that's a terrible bet
because it's all risk, no reward. But what if you
offered you a bet where if you get heads you
win thirty thousand dollars and if tails you'll still lose
twenty thousand. Would you take that bet?
Twenty thousand dollars is still a lot of money to lose, though,
and winning thirty thousand dollars doesn't feel like enough for
me to risk it.
Okayns, what if it's heads you win forty thousand dollars
and tails you still owe me twenty thousand.
Forty thousand dollars still isn't enough of a reward.
Naz, And this one's just for economic science. I'll give
you sixty thousand dollars its heads, tails you owe me
twenty thousand.
You in, I may start to consider it. If for
heads you pay me one hundred thousand dollars.
You're either a great negotiator or really risk averse. The
point here is that when there's enough of a reward,
you are willing to take the risk. That's why we
economists always talk about a risk reward trade off.
Everyone's going to answer this question differently because it's going
to depend on their level of risk aversion, and that
has a lot to do with their own personal diminishing
marginal utility of the extra money. Now, as you sound
like you're pretty risk averse here, but I think that's
because this is digging into what you'd use to pay
your rent.
Betsy's making a really important point. It says that you
can't just go to one of your friends and ask
them if you should take on some particular risk, and
that's because they don't know your attitudes, your perspectives, your
psychological makeup, and your life's circumstances. The only one who
knows all of that is you, and so the only
one who knows whether this is a risk that makes
sense for you is you. And that's why you need
to him yourself with a good understanding of risk and uncertainty.
This episode is making clear to me that I'm more
risk averse than I thought. However, there are strategies we
can use to reduce the amount of risk we take on.
And what's call is that we can apply these to
many areas of our lives, so it's not just about
our business or financial decisions. Our first strategy is something
called risk spreading, which is when we break a big
risk up into smaller risks which can then be spread
over many people.
So a good example is around starting your own business.
A lot of people want to do it, but it
can be really risky. So let's say you're starting a business.
Maybe it's an idea for an app, and you need
some developers and designers to work on it. You've looked
into the numbers and the data, and it'll cost you
two hundred thousand dollars to hire these people and to
cover the expenses for developing the app. There's a fifty
percent chance it'll be successful and give you a return
in the near future of four hundred thousand dollars.
And there's also fifty percent chance the app won't be
a success and you'll have lost the two hundred thousand
dollars you poured into it.
And now, as if I know you at all, well,
that's the sort of risk you feel that you don't
want to take on. But there is something you can do,
and that's to take on shareholders who which put in
a smaller amount of money into the app, so they
each put in one thousand dollars. If the app makes
a return, they make a return. And if the app
isn't a success, well a thousand bucks just isn't that
much to lose.
By simply breaking a big bet into many smaller bets,
you can transform a risk that's too much for any
one person to take on to one that makes sense
for people to take on if they're sharing it.
This comes out at diminishing marginal utility. And now, as
when you were thinking about taking on a bet, or
let's call it an investment that potentially meant losing twenty
thousand dollars with a chance to win sixty thousand dollars,
you didn't want to do it. But what if instead
it was a fifty percent chance of losing two hundred
dollars with a fifty chance of winning six hundred dollars.
I'd probably say that on if I lost the bet,
I wouldn't have to move house or anything.
Right. The problem is that with a big risk, the
loss digs deep into dollars that have a very high
marginal utility for you. Diminishing marginal utility means that the
last dollar you spend didn't generate as much utility for
you as the first dollar you spent. So big losses
get us down to dollars that are really important to
us in terms of our well being.
Let's push this logic. What if it was a bet
with a fifty percent chance of losing two dollars versus
a fifty percent chance of winning six dollars.
That sounds like a pretty good deal.
So when you break up big risks into smile risks,
you can take a lot of little gambles and make
yourself better off without risking a huge loss that leaves
you destitute.
When the stakes are high, most people want to make
risk averse choices. But if instead they can spread the
risk among a lot of people, that might really help.
If the stakes are small, you don't tend to feel
as risk averse.
The second way we can reduce risk is through diversification,
which is about combining many smaller risks which aren't very
closely related.
Oh yeah, nez, this is something we university professors to
do with our exams. If you were studying for an
econ exam, there's would you prefer one that had five
tru or false questions or one that had fifty true
or false questions?
Well, the paper with the five questions. The problem is
if you mess one up, then you really can't mess
the other four up. However, if there's fifty questions, then
you can get a few wrong and you can still
do pretty well on the paper, So each question carries
less weight.
The big picture here is when we diversify, we're basically
reducing our reliance on a single question, or a single
bit or a single stock in our portfolio, and as
a result, the overall outcome is less risky.
Now this rings a bell from one of our Macro
episodes about investing right.
We've always advised our listeners to put their money into
a diversified portfolio, which is exactly what Justin and an
idea instead of playing the stock market game and trying
to predict a few big winners.
When you're trying to diversify, one of the important things
to remember is that you get the benefits when you
take on risks that are unrelated to each other. So
if you want to diversify it, don't buy ten pharmaceutical
stocks because if something bad happened to the farmer sector,
you'd still lose all your cash. Instead, you want to
buy a whole lot of different stocks in different industries
that face different risks.
That's why we suggest you put your money into index funds,
such as a fund that buy shares from all the
companies on say the S and P five hundred index.
With index funds, you get a divers fied portfolio with
low risk.
We see it in other areas of our lives too.
If you're wearing a T shirt under you a sweatshirt,
and you've also got a waterproof coat with you, then
you're ready if the weather gets warmer or if it
starts raining. You've got a diversified clothing portfolio.
Our third strategy for reducing our risk is to take
out insurance.
When you buy insurance, the company is going to to
compensate you something bad happens, but in return you have
to give something up for sure, and that's the price
of the insurance. And an insurance markets that price is
called a premium.
Now, if you risk averse, you should buy actuarily fair insurance.
What that means is that's an insurance policy which on
average pays out as much in compensation as it receives
in premiums.
Okay, but most insurance isn't actuarily fair though in reality,
the insurance company has to take in more money in
premiums than what they're going to pay out for the
bad things that are insured. They need to pay their employees,
and they probably want to make a profit, but that's
going to create a dilemma for you. Buying insurance is
going to lower your risk, but because the insurance isn't
actuarily fair, you're gonna end up paying more for insurance
then you'll get back on average.
So insurance is another example of a risk reward trade off.
Insurance is likely to be worth it the closer it
is to being actuarily fair, and it's more likely to
be worth it the more risk averse you are and
the larger the stakes that are involved.
There's really important advice coming out of this. Most of
the time, insurance for small things like small appliances just
doesn't actually make sense. Companies are going to offer you
extended warranties, but typically at prices that are very far
from being actuarily fair. In other words, if you paid
all those premiums for small appliances into a bank account
instead of paying for the insurance. You'd probably be able
to pay for the repair or replacement yourself and still
have money left over.
This is an example with extended warranties where we've got
really small dollar stakes. These are losses that you can
afford to bear without having too much of an effect
on your well being.
But realize you need to consider your own personal risk,
because sometimes that will mean that the insurance is a
better or worse deal for you. For example, I buy
Apple Care for my phone because I have one hundred
percent chance of smashing the screen. That's really true. I
do so even though it's small dollars. The insurance is
even better than actuarily fair, since what I pay an
insurance is less than what I pay to replace the
screen without insurance.
It's ridiculous how much you smash phones. It's not a risk,
it's a certainty. But with most other appliances, the risk
isn't about your phone dropping behavior, So I stand by
my advice for other things you want to avoid this
small dollar insurance.
Our fourth strategy for learwing risk is hedging, which is
another way of saying offsetting your risks.
Hedging is one of those words. It makes me tune out.
Oh my god, I literally tuned out when you started
saying that, because hedging doesn't sound like it applies to life,
but it actually really does.
Hedging's when you acquire an offsetting risk. A hedge reduces
you downside risk, but it also reduces your upside risk.
The most important hedge most people can make is to
ensure that you aren't investing in the company you work for.
Let me be clear, she said, are not investing in
the company you work for.
Your annual income is already very linked to your employer's success,
so it's a good idea to have your wealth linked
to something else, anything else, because if you invest your
savings in your employer and your company fails, you're going
to lose your job and your savings.
By hedging, that is, by putting a savings elsewhere, you'll
miss out if the company you work for grows a lot,
but you'll still get the benefits of working for successful
company through raises and promotions.
So if your company offers you company stock at a discount,
it might make sense to buy it because of the discount,
but then sell it as soon as you can. Don't
be too loyal, and if you're really risk averse, then
that discount needs to be really big to buy it
at all.
The point is that buying your company's it's not a hedge,
it's an anti hedge.
Businesses also use hedging to manage risk. Airlines think about
this a lot because fuel is a really important cost
for them.
That's a great example. Now, Southwest Airlines is used hedging
as a way to try to stay consistently profitable. They
bet hundreds of millions of dollars that fuel prices will
be high, so that when fuel prices are high, the
hedge is going to offset their higher cost of fuel.
Finally, if you want to reduce your risk, you can
gather information to help you make the best decision.
Recall that you said if you wear a T shirt
under your sweatshirt and carry a waterproof coat, then you're
ready for both warm weather and for rain. Well, you
know what you could do instead, justin what you could
check out the weather forecast to make sure that you
dress appropriately for the forecast.
That sounds like a really simple example, and it's oddly
obvious when you just said it, Betsy, But you'd be
surprised at just how many risks simply reflect someone having
a lack of information.
For example, starting a business's risk. But you can lower
the risks and make better decisions if you research the
market and find out about demand for your product and
more details about your costs, relevant information about your rivals,
the state of the market in general, and much more.
Gathering more information reduces the risk you take on and
also helps you make better choices.
I feel like making good decisions about risk and uncertainty
is really important. So what are some lessons we can
take away.
When you're evaluating risk. Don't think about the financial payoff,
think about what it'll do to your well being or utility.
The second thing is there's a bunch of things you
can do to reduce risk, and we went through some
of those today that you can apply in your own life.
So at the end of today's episode, you got one
big choice. Continue making decisions about risk the way you
always have and risk making bad choices.
Or use the tools from today to start making better decisions.
Betsy, justin thank you, I'm going to be very very
careful next time someone suggests heads or tails to me.