Any significant decision making has to break through an iterative three layered P-conundrum.
- Possibilities
- Probabilities
- Pay-offs
A decision maker needs to analyse various scenarios that can play out, what are the probabilities of each of these scenarios playing out and what are the payoffs or outcomes if any of these possibilities play out.
Decision Makers tend to falter at each of these stages.
Possibilities – A chess player, while analysing next moves, can simply miss a scenario that can cost her the match.
Probabilities – We often get swayed by what is visible and ignore the probabilities. This typically happens when our perception of risk changes after a risky event. For example we stop taking flights after the news of a flight crash. Our chances of dying in a plane crash remains the same before and after that news, but the behaviour changes because of a change in the perception of risk. At other times, we tend to get rooted with base rates, and fail to update what is known as Bayesian Probability. This is most dangerous when one is dealing with Domino Effects. In vastly networked systems, as it is said, the flapping of wings by a butterfly in one corner of the world can cause a major storm in another part. When dealing with such Complex Systems, it is important to keep an eye on the 2nd order effects and dynamically update the probability of events unfolding one after the other.
Payoffs – Lining up possibilities & their probabilities does not mean focusing on the high probability event and ignoring the low ones. The fact that the probability of some events is low, means that few expect those possibilities to materialise. When such low probabilities materialise, they often bring a shock value with them, and hence a high impact (payoff). In 1992, George Soros made over ￡1 Billion profits by betting on one such low probability event playing out – Bank of England giving up on Fixed Exchange Rate Mechanism. Another more relevant example of ignoring Payoffs is related to Covid-19. People treat the virus lightly claiming that there is a low probability of them contracting it, leave aside dying. What they ignore is the fact that if they get infected with the virus, life gets messy exponentially for them, their family, their society, city, country, economy, humanity as a whole! Talk about the payoff!
As Nassim Taleb says,
“If there is a possibility of ruin, cost benefit analyses are no longer possible.”
As an Investor, it is important to analyse various scenarios that can play out, what are their probabilities, and most importantly what are the payoffs.
A quote from George Soros pertinent to the Payoffs:
“It’s not whether you’re right or wrong, but how much money you make when you’re right and how much you lose when you’re wrong.”
One important feature of the conundrum, before I close. Let’s go back to the start….The Conundrum is iterative. What do I mean by this?
At a given stage there are various possibilities, with various probabilities & payoffs. Eventually, one of the possibilities plays out with its outcomes. Once we reach that stage, new possibilities emerge. And the cycle starts all over again.
Going back to that Chess example..A player identifies a few possible moves. Once she decides on one of them, it sets a new set of possibilities based on how the other player responds. She might have already planned for those possibilities.
In real life, it is more complex. The environment is dynamically changing. Hence, in the subsequent stages, we encounter some possibilities that we have never imagined in the first stage. This is called Radical Emergence of Adjacent Possible. At any given stage, one can visualise only the adjacent possibilities. With every new stage, radical possibilities emerge, which were not visible or imagined in the original stage. This is typically how creativity or scientific knowledge evolves. New insights bring new questions or ideas, which only emerge when one gets to a certain stage.
This iterative process also gives one a chance to course correct. The decisions are made in accordance with the information available at that particular time. As one graduates from one stage to the next, there is an opportunity to observe the dynamism of the environment, orient probabilities and make new decisions.
This takes the shape of a continuously evolving process of decision making, which is not rooted in inward looking opinions, but is totally in sync with the ever changing environment – The Rational Flaneur Way!