How mangers can make the wrong decision by not understanding probabilities.

We human beings have a strange perception of risk, and a bias against losses.

A good example is given by Richard Thaler, a professor of Behavioural Science & Economics.

He was giving a class to 23 heads of Division of a major publishing company, so these re all business people at a very high level.

He offered them a theoretical project with a 50% chance of a $2,000,000 profit and a 50% chance of a $1,000,000 loss.

So what would you have said?

Of the 23 present, 3 said they would take the business opportunity.

The Chief Executive Officer was also present and was asked would he take the project. Yes, 23 times.

Richard Thaler’s comment to the CEO was that he had an institutional problem where the senior managers were afraid to take risks.

What should the Heads done?

50% of $2m = $1m profit
50% of $1m = $0.5m loss.

The Expected Value is therefore a $.5m profit.

Agreed as we have said before, if you only do it once, then there is a chance of either a $2m profit or $1m loss, you won’t get $.5m. But if done 23 times? The managers should have been prepared to take the risk

Read more about how people’s behaviour doesn’t take the real ‘maths of the world’ in to account in Prof Thaler’s book – Misbehaving.

About Jonathan Rooks

Jonathan is an accountant who specialises in Mangement Accounting, the running of a business. He works with and entrepreneurs to help them increase income and reduce costs.

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