I was talking to someone the other day about house prices. He was convinced that house prices have hit the bottom and there is only one direction it can go – up. He was convinced that the home prices will go up by 25% in the next five years. This is the classic optimism bias. We are all trained to just see the upside and ignore the downside. It is not a certainty that house prices will go up by 25%, there is a whole variety of scenarios, each with different probabilities. In statistics speak this is called a probability mass function.
Even when people take into account this uncertainty and assign a lower than 100% chance for the upside, they continue to look at only the gains and ignore losses. For example, let us say someone wants to buy a house for $1 million. If think that there is a 80% chance the house prices will go up by 25% in the next five years, they compute the return as .8*.25*1,000,000 = $200,000.
But what about the remaining 20% of the cases? If the prices remained same or rose slightly in these cases then it is not a problem. What if the prices go down by 10% in the remaining 20% of the cases? Their net return is now
200,000 – 0.2*0.1*1,000,000 = $180,000
Be it buying a house or starting a venture, by overestimating the upside and by ignoring the negative impact of downside, we all take bigger risks than the numbers warrant.
Next time someone in your business says, “there is a 80% chance we are going to get 25% return on this investment”, ask them how they arrived at the 80% number and what will happen in the remaining 20% of the case.