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How Representations of Knowledge Shape Actions

Ralph Hertwig and Renato Frey

In 2009 the world found itself in the midst of the worst recession since the Great Depression. Events thought of as extremely unlikely, such as the burst of the U.S. housing boom, the meltdown of the financial system, and the bankruptcy of colossal companies, happened in breathtakingly fast succession. Why was the world so badly prepared for these improbabilities? One explanation is that the crisis of the financial industry preceding the economic recession occurred because the industry’s supposedly optimal risk-management models failed to reckon with “black swans” (Taleb, 2007)—unexpected and unpredictable rare events that carry an enormous impact. Of course, modern risk-management paradigms were not alone in failing to take the black-swan event into account—so did individual players, such as many homeowners who could no longer afford their mortgages. Can psychological theories and findings account for such blind spots?

At first glance, the answer is no. Influential studies in behavioral decision research consistently suggest the opposite propensity: People are oversensitive to rare events. For example, they overestimate the chance of getting food poisoning or of contracting lung cancer from smoking (Lichtenstein, Slovic, Fischhoff, Layman, & Combs, 1978; Viscusi, 2002). Moreover, people are depicted as remembering past experiences by how they felt at their peak (rare moment) and end (Redelmeier & Kahneman, 1996). Such oversensitivity is not only empirically observed but also theoretically suggested. According to the most influential descriptive theory of risky choice, people overweight low-probability events (Tversky & Kahneman, 1992). In fact, cumulative prospect theory explains the puzzling co-occurrence of two

R. Hertwig (*)

Center of Adaptive Rationality (ARC), Max Planck Institute for Human Development, Berlin, Germany e-mail: This email address is being protected from spam bots, you need Javascript enabled to view it

R. Frey

Center for Cognitive and Decision Sciences (CDS), Department of Psychology, University of Basel , Basel , Switzerland

© The Author(s) 2017

P. Meusburger et al. (eds.), Knowledge and Action, Knowledge and Space 9, DOI 10.1007/978-3-319-44588-5_8

behaviors—that the same people who purchase lottery tickets promising tiny chances of winning (thus being risk-seeking) also take out insurance against tiny chances of damage (thus being risk averse; Friedman & Savage, 1948)—on the assumption that small probabilities receive too much weight.

In light of people’s ostensible oversensitivity to rare events, why did so many people, financial experts and laypeople alike, behave as though they were not cognizant of the rare events that triggered what some observers called a bona-fide depression (Posner, 2009)? Analyses have highlighted a variety of enabling factors, ranging from purportedly rational bankers who acted on strong incentives to take maximum risks in their lending (Posner, 2009) to humans’ “animal spirits” (Akerlof & Shiller, 2009). However, there is another possibly enabling condition. The customary portrayal of humans as being oversensitive to rare events obscures the evidence that people, when recruiting their experience sampled across time to make risky decisions, tend to accord rare events (such as the burst of housing bubbles) less weight than they deserve according to their objective probabilities.

 
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