Not a moment too soon

“At first glance, Homo sapiens is an unlikely contestant for taking over the world.”  Gerd Gigerenzer

Evolutionary biologists have identified that one of H. sapiens original competitive strengths was the ability to run for very long periods of time, chasing their prey to exhaustion.  Not a particularly powerful weapon.  For my money, in the primitive world, I would have choosen large teeth and blinding speed any day.

But that was not mankind’s only advantage.  Humans eventually found that we could use tools.  And best of all, man was one of the best on the planet (among larger life forms at least) in adapting.  In “Rationality for Mortals”, Gigerenzer calls the approach that humans used the “fast and frugal heuristic”.  With that approach, humans developed ways to best use both man’s limited natural and constantly growing artificial toolset adapting to the environment.  A heuristic is an approach to problem solving with partial information.

Gigenzer gives an example of a heuristic used by a baseball outfielder catching a fly ball.  You will see that in most cases that outfielder will catch the ball on the run.  That is because the natural heuristic is for the outfielder to keep moving and to make small adjustments to their position until they and the ball are in the same location.  Binocular vision does not necessarily give enough information soon enough to position properly.  But successive observations provided by moving approximates a much wider set of eyes.  The heuristic uses a skill that the human brain already has – the ability to process multiple images of the same object to develop a three dimensional view of the world.

Flash forward 10,000 years.  Zoom down into the world of insurance and pensions and you will find a conflict for the role of key decision maker.  On the one hand is the management (or in general insurance the underwriter), who is the product of tens of thousands of years of advances in the “fast and frugal heuristic” regarding the financial risks that insurers and pension plans have been running more or less profitably for a few hundred years.  Their ability to make judgments in this arena is honed by decades of experience avoiding the necessity to run down their prey for days until it dies of exhaustion.  Some of these heuristics can be readily explained to colleagues in the business decision making process, but some can not be put into words any better than a baseball player can explain exactly how they are able to hit a 95 mile per hour fastball.  Those heuristics are called “Gut instinct”.

In the other corner of this conflict are the actuaries.  Actuaries represent one of the most highly evolved specimens of scientific man.  Actuaries are trained to build sometimes excruciatingly complex models of small bits of the world to inform their decision making.  These actuarial models are fundamentally statistical in nature.  They rely upon a number of statistical laws for their power, such as the lay of large numbers and Bayes law.

There is a constant push and pull between the actuarial model builders and the heuristic weilders for the major decisions of the firm.  And since actuaries do not always win, there is a feeling of oppression.  There are jokes about the actuarial approach by the followers of the heuristic approach.

But in fact, the two approaches are closer than one might think from first (or even repeated) exposure to the issue.  Both approaches have at their core a Baysean view of how to get to the right decision.  That approach is to constantly update your decision making engine with new experiences.

The heuristic decision makers may cast a wider net for the information that they bring into their heuristic.  The modelers are usually limited to specifically quantifiable information that can be put into the model.  Since the heuristic group does not have a quantitative model, they do not have that constraint.  However, they have the disadvantage that they do not necessarily have a systematic way to incorporate new information.  The heruistic forming process is not necessarily a fully conscious process.  In fact, explanations of heuristics are usually post hoc, not really a part of the development process.

That flaw does not make heuristics something to sneer at.  Humans came to take over the world primarily because of this ability to create and update powerful heuristics.

The actuarial, statistical, quant approach to risk management and decision making is a development out of the scientific revolution.

Part of the scientific revolution was an effort to drive heuristics out of the position that they held in the area of major human decision making.  They did such a good job that it is often difficult for us modern people to even understand the pre-scientific revolution thinking processes and discussions.

We now favor evidence based logical reasoning.  Heuristics are often formed without any clear reasoning.  They just work.  But that heuristic thinking is also what we now call “judgment” that we are now trying to leven our quant approach to models with.   We say that without even noticing that this is a movement against the grain of several hundred years of scientific progress.

And not a moment too soon.

Explore posts in the same categories: Business, Enterprise Risk Management, People Risk


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