Against the Gods: The Remarkable Story of Risk

Chapter 16

The Failure of Invariance

All of us think of ourselves as rational beings even in times of crisis, applying the laws of probability in cool and calculated fashion to the choices that confront us. We like to believe we are above-average in skills, intelligence, farsightedness, experience, refinement, and leadership. Who admits to being an incompetent driver, a feckless debater, a stupid investor, or a person with an inferior taste in clothes?

Yet how realistic are such images? Not everyone can be above average. Furthermore, the most important decisions we make usually occur under complex, confusing, indistinct, or frightening conditions. Not much time to consult the laws of probability. Life is not a game of balla. It often comes trailing Kenneth Arrow’s clouds of vagueness.

And yet most humans are not utterly irrational beings who take risks without forethought or who hide in a closet when anxiety strikes. As we shall see, the evidence suggests that we reach decisions in accord with an underlying structure that enables us to function predictably and, in most instances, systematically. The issue, rather, is the degree to which the reality in which we make our decisions deviates from the rational decision models of the Bernoullis, Jevons, and von Neumann. Psychologists have spawned a cottage industry to explore the nature and causes of these deviations.

The classical models of rationality—the model on which game theory and most of Markowitz’s concepts are based—specifies ...