The Three Rs: Risk, Reward and Rationality
How much is something worth? More particularly, how much is something worth if we have to risk something to get it? This is the question at the heart of all decision-making under conditions of uncertainty. There is no such thing as a free lunch. To get something out, we have to put something in. For the sky diver, the thrill of jumping out of a plane must be weighed against the risk of his parachute not opening. For the smoker, the pleasure and relaxation given by the nicotine must be measured against the future possibility of cancer. For the stock investor, the hope that his investment will increase in value can be balanced against the risk that it will fall. For the roulette player betting red, his risk is that it will land black. Trying to measure the ability of something to satisfy needs or wants, particularly when faced with the prospect of losing, is the business of utility.
In 1979, two Israeli scientists, Daniel Kahneman and Amos Tversky, published a paper that was to fundamentally change the way we think about utility. It was the crowning achievement of a body of work the two of them had collaborated on for the best part of two decades. The examination of this and other cognitive errors that we make formed the basis of a large research framework that began to expose the weakness of the underlying assumption of the expected utility hypothesis: that we are rational creatures.