The Neuroscience Behind Bad Decisions with Money

The Allais paradox is a paradox about the psychology of how we make certain decisions. It’s like a game where you have two choices. In one choice, you have a 50% chance of winning $1,000 and a 50% chance of winning nothing. In the other choice, you have a 99% chance of winning $1,000 and a 1% chance of winning $1,000,000.

Which choice would you make? Most people would choose the second choice because they want to try to win the big prize, even though the expected value (the average amount you would win) is the same in both choices.

The Allais paradox shows that sometimes people don’t make decisions based on the expected value, but rather on other things like the chance of winning a big prize or the risk of losing everything. This can lead to decisions that don’t make sense, especially in situations where it’s important to make good decisions.

Put another way, the average person doesn’t crunch the numbers, use logical formulas, and identify what the optimal arithmetic decision is. Instead, they go off common judgement, assuming one choice is better. The second choice looks better because there’s zero chance of walking away with nothing, a very large chance of getting the max winnings of the first choice, and 1% of winning an extreme amount. However, a machine or AI would tell you that both options actually output the same amount over time.

This bias can hurt us in situations when we fail to see that both decisions are equal when they are. And this is just one example of many biases working together against you on a typical basis. The goal isn’t necessarily to be aware of all these biases, especially if your decisions don’t have to do with money. Instead, it’s to identify the big biases (affiliate link to a good book) and be aware of those.

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By Will Chou

I am the the founder of this site and I am grateful you are here to be part of this awesome community. I help hard-working Asian American Millennials get rich doing work they love.

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