Did I Wash My Hands? How to Manage Risk
I put the garbage out yesterday and came back to my room quickly. I had been concentrating on an article, so I wanted to start drafting right away. Just before my fingers touched my keyboard, I started to doubt myself. Did I wash my hands after taking out the trash?
My gut said I did. How could I forget–I had taken out trash for so many years. It was a routine to wash my hands so I must have done it. I was sure even though I couldn’t remember the details of going to the washroom and applying soap. I am sure about many things I can’t exactly remember. I mean, I can’t instantly recall what I ate for dinner a week ago, but I am 100% sure that I ate a full meal.
I convinced myself that I had in fact washed my hands. In summary, my reasoning answered the following question:
Question 1: Given uncertain circumstances, what is the most likely explanation?
I reasoned it was more likely to forget to remember a routine action than to forget to do a routine action.
Then I realized I was being dumb. This entire discussion was meaningless from a risk management perspective. This is the relevant question:
Question 2: Given uncertain circumstances, what is the action you should take?
I’m no risk expert, but I’ve done well with personal decisions by understanding why question 2 is more important than question 1. The likely causes may inform our actions, but that should be a secondary consideration. Because of this thinking, I have been a better investor, a better lender, a better friend, and a better student. It’s not a natural way to think, but as I’ll argue below, I think it’s the proper way to make risky decisions.
I’m going to analyze question 2 using the economic idea of “states of the world.” This basic technique is used by professional stock investors, insurance companies, military leaders, and central banks with more precise math. But the thought process is illustrated even through my own trivial dilemma of hand-washing.
States of the world
I either had washed my hands (W), or I had not washed them (N). These were the two possible “states of the world” that I faced. I was unsure which one I occupied.
I reflexively tried to figure out which state I actually was in. The more I thought, the more I ruled it likely that I was in state W. This means I put a low chance I was in state N, maybe something like 1%, or 0.05%, or 0.01%. Lacking photographic evidence, I couldn’t rule out state N. But if I were a betting man, I would bet the house that I had washed my hands.
In essence, I had answered question 1 satisfactorily. I figured out what was more likely and went with it. But acting on that would leave me open to the biggest risk: I could possibly use my computer with dirty hands. It might be an improbable event, but it would have an undesired impact.
Instead of debating which state I was in, I should have thought of a question 2. What was I intending to do? The real goal was to minimize contamination of my computer keyboard. What is the proper action?
When I think like that, it becomes immensely clear that if in doubt, I should wash my hands again. The action would lead to the states of either washed twice (WW) or not-wash, then wash (NW). In either case, I would be sure that I washed my hand at least once to spare my keyboard.
Was it wasteful that I could possibly wash my hands two times? Yes. It would be a waste of time and effort. But that cost is trivial compared to the damage of contaminating my keyboard if I were actually in state N. That funk would have persisted since my keyboard is very rarely washed. How often do you wash your keyboard?
To phrase it differently, the cost of washing my hands possibly for a second time is an insurance against dirtying my computer.
Good decisions don’t depend only on outcomes
The above example illustrates this point. The rule “If in doubt, wash hands” occasionally causes me to wash my hands twice. But it always avoids contaminating my computer keyboard. The lesson: think more about question 2 than about question 1.
Sports announcers don’t get this point. They often second guess player’s or coach’s actions because “they didn’t win the game” or “they didn’t get the job done.” You should judge a decision on how it would do on average, in other possible situations. But sports writers usually document how winners make the right “gutsy” calls and losers somehow “miscalculated.” The same criticism applies to stock analysts who praise stocks that rise and criticize company moves that turn out bad, but were actually a good idea. This topic is juicy, so more on this in a future article.
Further reading
I read a lot of books, and enjoy them, but it’s not often I find the books life-changing. And that’s why I’m stunned at my most recent coincidence of reading two life-changing books (recommended to me by a loyal reader).
They are both written by Nassim Nicholas Taleb, an essayist and scholar who used to be a mathematical trader. The books deal with randomness and how to manage risk. One of the main themes is to look for the highest impact events, which are often unexpected.
The books criticize traditional risk management techniques in a very amusing way. Taleb illustrates over and over how popular risk management techniques blow up because their predictions are based on inappropriate risk models. Surprisingly, the books use very little math to illustrate technical concepts. These are books I am going to refer to over and over again. My only major criticism is the writing style which is a bit peculiar. It has since grown on me as I can attest that I enjoy the style upon re-reading passages.
I would also warn that these are very skeptical books that might raise more questions than answers. Know you’re in for a bumpy ride that might challenge the way you or your friends make a living. (I know this first-hand as he makes fun of economics frequently and even jabs at game theory in one example.) But hey, I didn’t say it was a feel-good life changing experience for me, just a life-changing one 
The two books are Fooled by Randomness and The Black Swan. I like them so much that I’ve added a section to my sidebar called “Recommended Books” to point new readers to them.
I hope you find a copy of each and enjoy them as much as I have.
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7 Responses to “Did I Wash My Hands? How to Manage Risk”
We as individuals emphasize the result than the process of our decisions that enabled the results (good or bad). Robert Rubin, the secreatary of the Treasury under Clinton explained this phenomenon at a few of his commencement speeches and in his book, “In an uncertain World”. Strongly recommend the book and also a couple of links to his commencement addresses which embody that thought.
http://www.commencement.harvard.edu/2001/rubin.html
http://www.ustreas.gov/press/releases/rr3147.htm
By Mahesh on Mar 9, 2008
@Mahesh: Thanks for the tips. Rubin’s speeches are excellent–I highly recommend that readers check the speeches out.
By Presh Talwalkar on Mar 9, 2008
Hi Paresh.
Thx for recommending few good books.
Thx Mahesh for for Rubin’s speeches.
By Vijaya on Mar 16, 2008
Vijaya: Thanks! Glad you found the information useful.
By Presh Talwalkar on Mar 16, 2008
In this example, the cost of eliminating the risk was small — a possibly unnecessary hand washing, costing a few minutes/gallons of water, but guaranteeing avoidance of the ‘bad outcome’ (contaminated keyboard).
What if the cost of “insurance” were non-trivial (e.g., handwashing were painful, or if each handwashing significantly diminished your drinkable water supply)? At some point it becomes a better strategy to forego insurance and take the risk. In terms of expected value this depends on the cost of the insurance, the probability of the ‘bad event’ if you do vs. don’t take insurance, and the cost of the ‘bad event.’
I’m particularly interested in the limit where the probability of the bad event is low, but its cost is huge — and insurance is costly too. A practical example: generically, men/women have a ~10% chance of early death from prostate/breast cancer; “insurance” against this could be had (at a non-trivial cost) from preemptive prostatectomy/mastectomy. But this would be curative, and avoid early death (at least from the cancer).
What’s the right way to think about this problem? Lets say genetic counseling tells you you have an increased chance of getting such a cancer. You can have regular tests (incurring financial and emotional cost, not to mention some risk of missing the disease when its still curable) or the pre-emptive ‘ectomy (which carries its own risks and diminished quality of life — but at least you don’t die). What to do?
There are lots of risks we incur that have potentially catastrophic consequences (i.e. death, a seemingly infinite “cost”). For example, we do cross the street even though the gain in getting to the other side pales in comparison with DEATH. What’s the framework for thinking about this?
P.S. No, I’m not a crazy hypochondriac!
By Dan on May 26, 2008
Dan: You raise excellent questions about weighing the costs of expensive insurance versus taking the risk. I can’t say I have an answer, but let me discuss some ideas that come to mind.
The medical examples are particularly interesting because these are practical problems we face.
A very interesting thing is that there are many preventative measures that can be taken that are less intrusive, though certainly costly.
An example: one thing I’m reading about is that nutrition plays a huge role in activating disease. The book “The China Study” by T. Colin Campbell suggests a plant-based diet (no dairy, no meat) wards off against a variety of illnesses. Another book “Dr. Dean Ornish’s Program for Reversing Heart Disease” suggests that a program of meditation, a well balanced low-fat vegetarian diet, and exercise can actually reverse heart disease.
For an average American, these are huge costs to take. It is socially awkward at times to be a low-fat vegetarian or vegan. But then I remember that the average American gets heart disease. Many people are unwilling to take comprehensive changes.
Your example about crossing the street is very interesting too. Years ago I virtually stopped jaywalking for the very reason of eliminating catastrophic risk. I got made fun of a lot from my friends, but words do not hurt as much as a car collision.
I read somewhere that Nassim Taleb, author of “The Black Swan,” was going to write an entire book about dealing with such catastrophic risk.
I’m looking forward to it.
By Presh Talwalkar on May 27, 2008
it looks like a good job to be a risks maneger.
By fx trading on Jul 10, 2008