The High Cost of 'Noise' in Decision Making
(Bloomberg Opinion) -- How does “noise” affect decision making? According to Daniel Kahneman, winner of the 2002 Nobel Memorial Prize in Economic Sciences and this week’s guest on the Masters in Business podcast, it manifests as an interference in judgement, especially in institutional decision-making. We discuss the problem and his new book Noise: A Flaw in Human Judgment, which he wrote with Oliver Sibony and former Bloomberg Opinion columnist Cass Sunstein.
Kahneman explains why industry often assumes “noisy” errors cancel each other out. What actually occurs is that the errors add up. Two mistakes don’t average out to a single median good decision, but accumulate into several bad decisions. For example, Kahneman said he was surprised to learn how far off insurance executives’ estimates were for underwriting and appraisal variability. The executives thought the range might differ by as much as 10%, but it was actually 55% -- an expensive error for insurers that could add up to millions or even billions of dollars in lost opportunities and excess claims payments.
Some industries such as commercial aviation tend to identify and manage noise well. Other industries consciously ignore it. We discuss how admissions committees used to do blind reviews of applicants, with groups of people arguing for and against candidates. But many admission committees changed this approach, and now an initial reviewer scores a candidate and then passes the application to the next person on the committee. Built-up biases --arguably -- worsen the outcomes, but also reduce disagreements within the committee.
Be sure to check out our Masters in Business podcast next week with Scott Sperling, co-chief executive officer of private equity firm Thomas H. Lee Partners. Sperling is a member of the firm’s management and investment committees. THL has completed more than 100 investments, spending in excess of $125 billion. Its flagship fund has more than $5 billion.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Barry Ritholtz is a Bloomberg Opinion columnist. He is chairman and chief investment officer of Ritholtz Wealth Management, and was previously chief market strategist at Maxim Group. He is the author of “Bailout Nation.”
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