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Wednesday, December 7, 2011

Cognitive Mistakes
Mike Rappaport

This website is for poker, but it lists 23 cognitive mistakes that people are prone to making in all areas of life.  I haven't found any more useful lists of cognitive mistakes, so I am posting it here. 

http://rightcoast.typepad.com/rightcoast/2011/12/cognitive-mistakesmike-rappaport.html

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Comments

A serious and widespread fallacy nowadays involves insurance. When a catastrophe occurs (someone's house burns down), there's always someone around (usually on NPR)who'll remark, "But fortunately, the loss was covered by insurance."

The lesson implied is, "Don't be so foolish as to go without insurance."

This logic ignores (and NPR never reports on) the thousands of days folks spend fully insured in Peoria, where nothing ever happens.

While the return on common types of insurance is around 50% to 80%, if it were 1%, we'd still have those occasional and deceptive reports implying that it makes sense to carry insurance.

It never makes economic sense to carry insurance, of course, unless you can trade on private knowledge that the insurer is unaware of or you can get greater fools to participate in the pool.

Posted by: jim kirby | Dec 8, 2011 8:23:41 AM

Jim - I disagree.

The spreading the risk aspect has value (even knowing the company makes a reasonable to very good profit, that you pay for too).

Posted by: krm | Dec 8, 2011 12:29:59 PM

Krm,

I guess you're one of those "greater fools" who hasn't mastered probability or investment theory.

Posted by: jim kirby | Dec 8, 2011 5:30:46 PM

Jim,

Your statement here is puzzling:

It never makes economic sense to carry insurance, of course, unless you can trade on private knowledge that the insurer is unaware of or you can get greater fools to participate in the pool.

You are right -- you don't ususally make money from insurance. But you reduce risk and people value that. So it makes economic sense to insure, even though you lose money. It also makes economic sense to buy a TV, even though you lose money.

Posted by: Mike Rappaport | Dec 8, 2011 5:45:04 PM

Of course, any amount of expense is justified if it gives you great psychic benefit. But seen as a pure economics exercise, it amounts to this:

You are invited to play a game in which you throw a pair of dice, paying a dollar (the insurance premium) each time, with the promise that if you roll snake's eyes (the catastrophe), you will be paid $30. You would be a fool to play.

That is the insurance game. Only fools play. Unless, of course, you get some psychic benefit from "spreading the risk," otherwise known as being royally screwed.

This thread started out being about poker, right?

Posted by: jim kirby | Dec 8, 2011 8:35:39 PM

Isn't the better analogy that you are *forced* to play a game in which you throw a 100-sided (or whatever arbitrarily large number you like) die, and if it comes up 1, you will have to pay $10000; and any other number, you pay nothing. You cannot avoid playing the game, except by paying $105 (or whatever). Your expected value is certainly better to play the game than to pay, but, as Mike Rappaport notes, it would still be rational, given risk aversion, to pay to avoid the game.

Posted by: Tung Yin | Dec 9, 2011 2:10:32 PM

Tung Yin:

First of all, a posture of "risk aversion" is OK, unless forced on someone who likes to climb Everest, ride motorcycles or have sex.

Second, just consider the accounting: The insurer takes in $1,000,000 in a year to insure 1000 people, pays $200,000 in expenses for advertising, administration and lawyers, pays out $600,000 in claims, earning $200,000 profit in the year.

The 1000 insured folks have paid in premiums an average of $1000 and have received an average of $600 in claims, losing an average of $400 per person in the year.

Posted by: jim kirby | Dec 9, 2011 5:25:42 PM