In recent weeks I have described how people think about risk. They use approaches very different from those implied by the models of quantitative finance and decision theory. They are influenced by what is salient, rather than what is probable. Events that are phenomenally unlikely – the winning of a large prize in the lottery or a child’s abduction by a paedophile – influence their thinking to a disproportionate degree because they grab attention. Few people think of uncertainty in terms of statistical distributions and are able to attach probabilities that add up to one to a well defined set of disparate outcomes. They tell stories about the future instead.
We do these things not because we are irrational – in any ordinary sense of the word – or because we are mathematically illiterate, although many people who make decisions, big and small, are indeed irrational and ignorant of basic maths. We do these things because it is impossible to cope with a complex world and the plethora of information about it we encounter in other ways.
Everyone knows of John Maynard Keynes’s ideas on macroeconomic policy but far fewer know of his contributions to the theory of probability. This was the subject of his fellowship dissertation at King’s College, Cambridge before the first world war. Keynes got the post, and quickly established himself as a public figure. After he had walked out in disgust from the Versailles conference that – temporarily – brought the war to an end, he turned the exercise into a book.
