Or how to improve your probability ...

I cannot get over this book. Fooled By Randomness so vividly describes how we human do not understand how randomness fools us.

One fact that emerges out of this book is that traders take probability of an event occurring as risk while actually it is the value associated with the risk that needs to be considered.

I therefore decided to test out this hypothesis.

I asked a family member if she would place a bet on a game if there was 99% probability of winning Rs.100 but only 1% probability of losing Rs.100,000. The answer came almost immediately, "yes". I then asked her the second question. Would she undergo an eye operation which has 99% probability of perfect eyesight post-operation but only 1% chances of losing the eye. "Are you crazy?" was the answer.

My conclusion: people understand risk when the value is more personal. The first question remains in the realm of the hypothetical. Though the value is negative, there is actually no such game and she would not lose any money since we are not playing one. But an eye? We understand the value of losing an eye. That is more immediate. I am not a trader but I can now guess why brokers do not worry about value while taking risk. It is not their money - most of the time. The thought of a loss does not hit them hard enough as the thought of losing an eye would. Therein lies the difference.

But wait there is more.

The above incidence happened a few days ago. Yesterday a colleague asked me if I have seen the movie "21". She then asked me why switching the choice of the closed door in the game show would result in 67% probability of winning, when it is obvious that the probability is 50%. (In the movie the professor asks the protagonist the famous Monty Hall Problem, in which the game host offers the player a chance to switch the door after he has revealed that one of the doors not chosen does not contain a valuable item.)

If you follow the this link you will get an answer. But what is important to understand is that not only do human beings react to probability in a very simplistic way but we also refuse to believe that an action by someone could change the probability, especially when that person is in possession of some knowledge that you do not have.

We tend to treat all events as independent. Just like the previous roll of dice has no impact on the next roll of dice. But that is not correct with life except for some very simplistic cases. If you are appearing for an interview in a job, assuming it is a fair selection process, do you think that every candidate has equal chance of selection? Wrong. Your chance depends on who has gone before you. If the candidate before you impresses the selection committee, unless you are superlative, your chances reduce.