The Limits of Intuition

Human brains have been wired through years of evolution to think intuitively. This fast, emotional and automatic way of thinking was useful for our ancestors in navigating the Savannah of East Africa and escaping lions. If a lion was chasing you, spending too much time deliberating whether it is friendly or not wouldn’t end well for you. While this type of rapid thinking is useful in making snap judgements in our day to day lives, it can have bad outcomes in investing.

To understand the limits of intuition, consider this. Imagine you have a child who wants to be an actor. He is really passionate about it, takes part in school plays and everyone says he will be a good actor. As he grows older, every casting agent he meets says he is very talented and his chances of making it to the big screen are 95%. This seems like fantastically good odds especially because professional casting agents have seen lots of talent over the years and they have been wrong only 5% of the time i.e. 95% accurate.

Intuitively, his odds of making it as an actor are 95%. Even if the casting agents are a bit off for whatever reason, it seems likely that his odds are, at the very least more than 50% i.e. he is more likely than not, to end up being an actor.

The actual probabilities are, unfortunately, much lower. In the USA – the world capital for movies and TV, there are 160 million people in the labour force and only about 30 thousand full-time actors. Actors only make up 0.02% of the population so the prior probability of anyone becoming an actor is only 0.02%. Therefore, the actual probability of this child being an actor (maths behind Bayes Theorem explained here) is only 0.4% – much better than the average person but still remarkably lower than 95% chance given by the casting agent.

While his odds of being an actor are much slimmer than our intuitions would admit, this is not to say that every decision in life should be brutally calculated based on the odds of success. Taking chances and having a good time are also important.

In investing, taking chances and having a good time is a bad approach. Preserving and growing capital in real terms requires a good understanding of the prior probabilities to make better informed decisions.

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