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"If a genius stands up to a tank driven by a dunderhead, bet on the tank." H.W. Lewis
Why Flip A Coin?
The Art and Science of Good Decisions
By H. W. Lewis
If you liked Chapter 8, Expectation Values and Decision Making of Thinking Like An Entrepreneur, you'll love Why Flip A Coin? The Art and Science of Good Decisions by H. W. Lewis.
Why Flip A Coin? teaches readers the rational process behind good decision making. H.W. Lewis writes: "So how do we give decision making our best shot, now that we have the tools? We have to put together the list of possible actions, the possible consequences of each action, the probabilities (expressed somehow, the more carefully the better) that each consequence will follow from each action, and finally we have to put a value on the joy or grief that each of these consequences may bring to you, the decision maker. Then, from all that, we have to find the expected value or utility of each possible action and choose the best. It sounds complicated, but really isn't, and even trying to go through the process can force us to think. We don't have to do it perfectly to stay ahead of the game. In the real world, we don't have to do anything perfectly to stay ahead of the game."
The book starts off discussing the dating game. How do we find the best mate? What the heck does mathematics have to do with that? If you want to select the best spouse (rated by some criteria you've chosen) from a group of one hundred willing applicants, you have several ways to approach this decision.
In the game, you are only allowed to date each potential candidate once. If you reject the candidate, the candidate lost forever, as he/she joins the monastery. How do you make your decision?
If you just select the first potential spouse who comes along, you only have a 1/100 chance that you will select the best. That's not very good odds, as many people have discovered! Suppose however, that you date the first ten potential spouses as a sample. You then use this sample as a guide to what's out there. As Lewis writes, that's what dating's all about!
By selecting the next potential spouse (after the first ten) who ranks higher than any of the sample of ten, you now have a 1/4 chance of getting the best. That's a far better chance than selecting at random!
But, there are two ways your strategy could fail. First, the best spouse might have been within the group of the first ten. Then, you missed the best spouse. Second, the eleventh person chosen might be better than any of the first ten, but he/she might not be that good either. In fact, the candidate could be the eleventh worst.
However, another question is: Just how important is it to select the best mate from the lot? Would not one of the top five be adequate? Especially, if you minimize the chances of winding up with a real dud? By playing more conservatively and only sampling the first 30, your chances of getting the best decreases only slightly, but your chances of getting either the best or the second best increases to 1/2.
By understanding the dating game, you've gone from having only a 2% chance of winding up with one of the top two spouses to having a 50% chance of getting one of the top two spouses!
Of course in real life we face other problems, such as idealizing someone we dated long ago. We might bump them up to an unrealistically high rating against whom no one can compete! Maybe, some potential spouses just won't date us. And, it wouldn't go over too well to tell a potential spouse "I really like you a lot but you're only number 28. I'm waiting till I've dated 30 to commit!" Nonetheless, in our example, we can greatly increase our decision-making above the 1/100 chance of getting the best by random selection.
So much for the metrics of mating. Even without understanding the full mathematical details, we can benefit from seeing the logic of sampling some of the population before making a choice. In fact, Why Flip A Coin? doesn't work out the complicated mathematics. It just states the odds to make the point. We don't need to be able to work out detailed mathematics to be able to make better decisions, in general. We do need to think about the logical process used in making the decision.
Lewis does a great job of explaining hedging. He uses a football pool as an example. There are only two teams, The Ducks and The Geese. And, there is only one other person, Fred, betting. Assume each team is equally likely to win.
Fred puts $1 into the pool and chooses The Ducks. What do you do? You toss in a buck for The Ducks, and you toss in a buck for The Geese. You bet on both teams. You hedge. There is now $3 in the pot.
Expected Winnings = 1/2 ($1.50) + 1/2 ($3.00) = $2.25 which is more than the two dollars you wagered. In fact, the expected return here is 12.5%. Via hedging, despite having no superior knowledge of which team will win, in the long run, you come out ahead.
As Lewis writes, don't go betting your money on football pools just because you know this! Someone who posses superior knowledge of which team is most likely to win in the real world has the advantage.
Much of Why Flip A Coin? is devoted to group decision making and the social implications of the way group decisions are made. In particular, the book discusses voting, the electoral college, and how difficult it is to translate the wishes of a group of people into a collective decision.
Lewis gives the example of an election between three candidates. He shows three reasonable voting schemes each leading to a different winner (Don't give this book to Al Gore, it will keep him up at nights.)
Lewis possesses insight into representative government and how decisions in representative government are made. He writes "[T]he decision maker must have a stake in both the costs and benefits of a decision. Without that, there is no compelling incentive to make responsible decisions, and failure is both inevitable and predictable. ... it is too much to expect people to be prudent in the use of other people's resources."
Lewis goes on to say: "About 60 percent of the federal income taxes paid to the Internal Revenue Service comes from 10 percent of the taxpayers. And there are even more voters than there are taxpayers, so ultimate decision-making authority on the expenditure of public funds in our country resides overwhelmingly in the hands of those who will not pay for the decisions they make. That paves the way for the enormous (and growing) national debt, the equally enormous deficit with which our government works each year (an option denied us as individuals), and the unstoppable growth in so-called entitlement programs. When the beneficiaries of the programs are not the payers, what could be more natural? Within our system nothing can be done about it, since a politician who promises us more benefits, paid for by anonymous others, has an edge over one who asks us to make hard choices. ..."
One chapter, about investing in the broader stock market, focuses upon issues of volatility. Lewis concludes that: "any effort to apply solid decision-making methods to optimizing gains in the stock market has therefore to be sophisticated, and has to deal with these confounding statistical features."
I disagree. Choose great companies that have great growth prospects and hold them. That's your best strategy. Using beta as a measure of volatility and choosing a portfolio of volatile stocks for the sake of volatility is silly (but seems to be what Lewis recommends). Among a collection of high beta stocks (volatile stocks) many are truly crappy companies with little chance of being around in fifteen years. It's silly to put an obviously crummy company in a portfolio! In any case, Why Flip A Coin? isn't a book about just investing, so we won't be too critical of Lewis here.
Lewis does acknowledge that individual investors with knowledge superior to the collective market can beat the market. Such investors will skip statistical analysis in favor of careful stock selection. However, lacking special business insight, Lewis contends that understanding statistical methods give investors the best chance of success. Of course, the goal in investing is to learn enough to make very knowledgeable and informed decisions, allowing you to select superior stocks.
Lewis writes: "[T]he more you know about the world you live in, the richer and more satisfying your life will be, and the more effective you will be at everything you do." While that seems something we all want to believe, especially if we see ourselves as having a great understanding of the world, this is far from established as fact.
Many of the greatest physicists and mathematicians had vast understandings of the world, but didn't have tremendously happy lives, nor were they particularly effective outside their specialty. In any case, if you're willing to think a bit (and risk knowing a little bit more, for better or worse), Why Flip A Coin? The Art and Science of Good Decisions will give you much to contemplate.
If you want to understand the process of making good decisions, and improve your own decision-making ability, I highly recommend this book.
The Art and Science of Good Decisions