“Larry, a caring and empathetic soul, enjoys being helpful whenever he can. He is a happy person by all accounts and likes interacting with people of all ages.”
Loading ...
If you chose “veterinarian”, you are wrong. This is your brain relying on what Daniel Kahneman has named “System 1” thinking. System 1 is intuitive, automatic, and effortless, answering questions quickly through associations and heuristics. The specific error you likely made in answering the above is referred to as representativeness.
Representativeness is when we judge the probability that an object or event “A” belongs to class “B” by looking at how closely “A” qualitatively resembles our mental description of “B”. This is one of the bedrock heuristics found in behavioral economics. It also helps explain why stereotypes exist and persist as well as why we have a strong tendency for reasoning by analogy.
The question above exploits the fact that very few of us think of accountants as caring and empathetic individuals who enjoy others.
So why are you wrong?
Most people weight their own information and beliefs too heavily. The best course of action is to start with what Kahneman, Tversky, and Tetlock have referred to as the base rate. The base rate is simply an examination of what has happened in similar situations in the past or what the current data objectively depicts. This requires overriding your impulsive System 1 and employing your effortful System 2.
According to the US Bureau of Labor Statistics, there are roughly 17.5 times more accountants (1,397,700) than veterinarians (79,600). If you assume Larry must be either an accountant or veterinarian then the base rate for him being an accountant is just under 95%. In other words, there’s a 95% chance Larry is an accountant and a 5% chance he is a veterinarian. The answer does not change if you include the hundreds of other occupational options available to Larry, only the #’s change.
System 2, as Kahneman described in Thinking, Fast and Slow, is the deliberate, controlled, and slow kind of thinking that requires mental effort. Given the fact that we all have a bias toward maintaining cognitive ease, it’s hard to invoke System 2. Slowing down to logically work your way through a problem, find data, and calculate probabilities is work. The same way it’s hard to build the habit of exercising on a regular basis.
Implications
As nearly all research on the topic of decision-making states, we get by just fine the vast majority of the time. Not all of our decisions require statistical analysis. So where should we spend more effort using System 2 thinking?
In general, the decisions that have long-term implications, are hard to reverse, and/or involve high stakes. Investment decisions, which are near and dear to my heart by way of background come to mind.
If you work with a Financial Advisor, he or she may or may not have you allocated to actively managed equity mutual funds. Those who ascribe to a passive management philosophy often cite market efficiency as the reason for buying index funds. Those who choose actively managed funds are likely falling victim to the representativeness heuristic above, among others. They choose some manager based on an attractive narrative that matches what they believe leads to success.
In both cases, the rationale could be improved by incorporating the base rate. Take US Equity Large Cap Funds for example. According to the SPIVA Reports produced by S&P Dow Jones, just over 84% of US Large Cap (USLC) Mutual Funds underperformed the S&P 500 over the last five years. This means the base rate of success you can expect for selecting a mutual fund in this space is about 16%. Let me reiterate, you and I have a ~16% chance of selecting a USLC fund that outperforms over 5 year periods, pre-tax, out of the gate.
With those odds, why would anyone even bother trying to select an active US Large Cap manager? I can think of only two reasons. One, they have misaligned incentives. Two, they simply do not know any better.