Risk-Savvy: How to Make Good Decisions
Read the first part on my LinkedIn here
The book starts with the concept of “risk savviness” and why it’s important. Gigerenzer points out that people often make irrational decisions when they’re presented with complex information about risk. He argues that this is because we’re wired to rely on heuristics to simplify decision-making, but we’re often taught to distrust them in favor of more complex models. Gigerenzer believes that embracing heuristics in certain conditions can lead to better decisions
Gigerenzer then introduces a number of heuristics that people can use to make better decisions. One of the most interesting heuristics is satisficing. Satisficing suggest people to choose an option that is “good enough” rather than searching for the optimal solution. Satisficing can acts as a brake to overthinking: striving for the best possible outcome. Instead, people can focus on finding an outcome that is satisfactory and meets their needs. It is best used in situations where there is a lot of uncertainty or complexity where the “best” possible outcome may not be achievable or realistic.
Gigerenzer also explains on applying the heuristics he’s discussed to real-world scenarios. He provides examples of how these heuristics have been used to improve decision-making in fields such as medicine, finance, and the environment. He also discusses how governments and organizations can help people become more “risk savvy” by providing more accessible information about risk.
Here are my key takeaways from the book:
Risk and Uncertainty
Risk and uncertainty are sometimes used interchangeably as if they have the same meaning. Gigerenzer made it clear that the difference lies in whether or not the risk is known. Known risk, or simply risk, is what we typically think of as risk, whereas uncertainty arises when the risk is unknown. The opposite of uncertainty is certainty.
When dealing with risk, one thing to avoid is mistaking risks for certainties or mistaking uncertainties for risks. This is called The Illusion of Uncertainty.
Smart heuristics/rule of thumbs
1/N or Equality Heuristics
Allocate your money equally to each of N funds.
Harry Markowitz won a Nobel Prize in economics for proposing a solution to portfolio management called mean-variance portfolio. The portfolio maximizes the gain (mean) for a given risk or minimizes the risks (var) for a given return.
In a study, researchers compared the performance of 1/N versus mean-variance and 12 complex investment methods. The results showed that in 6 out of 7 tests, 1/N scored better than mean-variance. Even Harry Markowitz himself uses 1/N.
An example of 1/N is when you put 1/3 in stocks, 1/3 in bonds, and 1/3 in real estate. Before implementing this strategy, it’s important to do your homework on how large N should be, what kind of stocks to invest in, and when to rebalance.
Recognition heuristic
It is another important rule of thumb. Gigerenzer suggests that recognizing an option is often a good indicator of its quality. For example, choosing a well-known restaurant, even if you don’t know anything about the food, is often a good strategy because popular things tend to be of higher quality.
Minimax Rule
Choose the alternative that avoid the worst outcome
The minimax rule aims to minimize losses in the worst-case scenario. For instance, imagine you apply for jobs at two companies and receive an offer from Company A with a deadline. While you prefer Company B, you haven’t received an offer from them yet, and the deadline is approaching. On the deadline day, you have two options:
- Accept the offer from Company A before the deadline, even though you prefer Company B. This guarantees that you have at least one job offer in hand.
- Decline the offer from Company A and wait to hear from Company B. This carries the risk of not receiving an offer from Company B and ending up with no job offers.
According to the minimax rule, it’s better to choose the first option.
Fast and Frugal Decision Making
Satisficing: go for a something that is good enough, not the best
Satisficing is a heuristic that can save you time and prevent overthinking. Instead of searching for the best option, you choose an option that is good enough. You set an aspiration level, a point where an option is considered good enough, and then choose the first alternative that meets that level, and stop searching. This heuristic is applicable when deciding what movie to watch, clothes to buy, or the purchase/sell price of stocks.
One-reason decision making
Find the most important reason and ignore the rest
This heuristic suggests that when we’re presented with a choice between two options, we should choose the one that has the most important positive feature. For example, if you’re trying to decide which house to buy, you might focus on the one with the best school district, even if it’s not as large as another option. This strategy is based on the idea that most decisions are made by considering only a few key factors, so it’s important to focus on the most important ones.
No look coin flip
Throw a coin but don’t look at the result
Try this simple decision-making exercise: toss a coin, but don’t look at the result. As the coin is spinning, you’ll likely feel a preference for one side over the other. Listen to that inner voice, make your decision, and don’t worry about the result.
Safety leverage rule
Don’t use leverage ratios above 10:1
To measure leverage, divide liabilities by capital. A ratio not exceeding 10 is considered safe. For example, if you owe money to the bank but have 30m in savings, you shouldn’t owe more than 300m according to this rule.
3x -COGS pricing
The right pricing can be hard to obtain as it requires many indicators to consider. Some even contain uncertainty. The easiest way to do it is by multiplying the cost of production n times.
Disclaimer
Do it with caution as too much reliance on heuristics and mental shortcuts may lead to suboptimal decisions in some situations.
That’s All. Thanks for reading! I hope you found my summary of Risk Savvy helpful and that you’re inspired to learn more about the fascinating world of risk.
