23 August 2012

Eggs, Baskets, Money and Children

I assume that in every culture there is a saying very close to “don’t put all the eggs in one basket”. This piece of popular wisdom is a very rudimentary but effective way of risk management. After all if the eggs are not all in one single basket, the risk is spread and in the case of a bad event, the damage is limited.

Now, let me give you a very simple problem: You have 6 (six) eggs and 3 (three) baskets in which you can carry the eggs. How do you allocate the eggs to the baskets? Namely how many eggs do you put in each basket??

Take 15 seconds to think….

Most likely you decided to put 2 (two) eggs in each of the 3 (three) baskets. After all it makes perfect sense since risk is equally divided and any second grade child knows that six divided by three is two (6/3=2).
But now take a deep breath and think WHY you decided to spread the eggs equally among baskets.

The fast thinking that lead to putting two eggs in each basket is called the “1/N” heuristic. And as its name says, when people have to divide (allocate) resources they usually give equal portions to each recipient (in our case baskets).

But does it make full sense? Think what do you know about the baskets that I told you about? Nothing. Just that there are three of them. But what if one is broken and for sure when you will lift it the eggs will fall out of it? Would you still put two eggs in each basket? Most likely the answer is NO. What about the size of the baskets? Do 2 eggs fit in each of them?

The thought exercise can continue, but I guess you realized what “the lesson” is here. Sometimes we make decisions just by applying a simple and naïve rule such as “1/N”. At the same time these decisions can have a big impact on our wellbeing. Let me give some examples…

When someone makes the decision to invest their savings… do they put half in stocks and half in bonds? Or do they put half in the bank and another half in real estate (not that I recommend these investments in any way)? How good is the huge majority of people at predicting the profit or losses of these investments.

When a family has children parents tend to treat them equally using the 1/N heuristic in allocating time and parental investment. And this seems fair enough, right? But if the children are more than 2 and they are not born at the same time, do they actually get equal parental investment over time? The answer is NO and someone wants to do the math, feel free.

In brief… make sure that you know at least something about the baskets in which you’re putting the eggs; and don’t forget about the time factor… what is equal at a point in time does not mean that it is equal over time.

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