Red-Blooded Risk: The Secret History of Wall Street

Rationality

This is a deep insight into the nature of risk, money, and rationality. Suppose I observe that you will bet one apple against one orange on some event. I don't know what probability you assign to the event, because I can't divide apples by oranges. But then suppose I see you trade one apple for two oranges. Now I know you were giving two to one odds, meaning you think the event has at least two chances in three of occurring. I have separated your decisions into preferences—how much you like apples versus oranges—and beliefs—how likely you think the event is. This is the basic separation required for the modern idea of rationality, the assumption underlying most modern economic utility theory. It depends crucially on both gambling and exchange—on randomness and money.

A little reflection will show that this separation is entirely arbitrary. It's not how you think about risk. Suppose you're driving along an unfamiliar road and see that you're low on gas. You see a gas station charging 15 cents a gallon more than you usually pay. You have to decide whether to stop and pay the extra for at least a partial tank, or to drive on hoping to find a cheaper station before you run out of gas. In conventional theory, you estimate the probability and cost of running out of gas before finding another station, and also the probability distribution of gas prices at stations up the road. You have to also weigh the value of money versus the inconvenience of running out of gas. But no ...