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Wisdom to Live Free from Finance and Thinking

How to Decide under uncertainty

Here are a few basic categories that decisions fall into.

There are decisions where:

  1. Outcomes are known. In this case, the range of outcomes is known and the individual outcome is also known. This is the easiest way to make decisions. If I hold out my hand and drop a ball, it will fall to the ground. I know this with near certainty.
  2. Outcomes are unknown, but probabilities are known. In this case, the range of outcomes are known but the individual outcome is unknown. This is risk. Think of this as going to Vegas and gambling. Before you set foot at the table, all of the outcomes are known as are the probabilities of each. No outcome surprises an objective third party.
  3. Outcomes are unknown and probabilities are unknown. In this case, the distribution of outcomes are unknown and the individual outcomes are necessarily unknown. This is uncertainty.

We often think we’re making decisions in #2 but we’re really operating in #3. The difference may seem trivial but it makes a world of difference.

Decisions Under Uncertainty

Ignorance is a state of the world where some possible outcomes are unknown: when we’ve moved from #2 to #3.

One way to realize how ignorant we are is to look back, read some old newspapers, and see how often the world did something that wasn’t even imagined.

Some examples include the Arab Spring, the collapse of the Soviet Union, the financial meltdown.

We’re prepared for a world much like #2 — the world of risk, with known outcomes and probability that can be estimated, yet we live in a world with a closer resemblance to #3.

alokranjan

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