YourCircleofCompetence 117quire dfor a particular decision varies with the probable payoff from
being right compare dto the probable loss from being wrong.^7 If the
payoff from being right is very high compare dto the loss from being
wrong (say, gaining $99 versus losing $1), this view says you can
reduce the required confidence level substantially—maybe to as low
as 1%. People who buy lottery tickets reflect this kin dof decision
making.
If the gain-loss matrix goes the other way (say, gaining only $1
versus losing $99), then you woul dinsist on a much greater confi-
dence level—maybe nearly 100%. These are the sure bets in life. And
as even the most steadfast gambler knows, there is no such thing as
a sure bet.
Your risk appetite will determine the sort of decision maker that
best suits your own psychology. Losses are inevitable. If they make
your misery index soar, stick with conservative approaches; if you
can tolerate them, a more aggressive approach is defensible. (Be-
ware: most people weigh losses more heavily than gains by a factor
of about 2.5.)
Buffett is a conservative decision maker. Explaining Berkshire’s
conservative financial policy of using little debt, Buffett says that if
there were a 99% probability that higher leverage woul dpro duce
something goo dan da 1% chance of a surprise that woul dpro duce
something between anguish an d default, he woul dnot bite that bul-
let: “We wouldn’t have liked those 99:1 odds—and never will. A small
chance of distress or disgrace cannot, in our view, be offset by a
large chance of extra returns.”^8
Graham was also cautious, warning investors to avoi dventures
with little to gain an dmuch to lose.^9 He advised forming judgments
on the basis of knowledge and experience, not on the basis of opti-
mism (valuable in many settings but not in investing; Buffett calls
optimism the “enemy of the rational buyer”).^10
Graham an dBuffett’s views reflect contemporary social psy-
chology. Research in this fiel dshows that in any decision-making
process, the cognitive weaknesses share dby most people pro duce
subconscious errors of judgment. The main cognitive biases in rea-
soning that investors nee dto worry about are the following:
- Overconfidence and superiority: believing you are certain when
you are only pretty sure (or believing you are pretty sure when you
are uncertain) an dbelieving you are better than average (the Lake
Woebegon syndrome).