Making rational decisions in a complex world
It’s no secret that we live in an increasingly complex world. It seems like there is always another variable to consider, another risk to mitigate. With all of these ever-changing and constantly moving pieces, how are we supposed to make sound decisions?
The prisoner’s dilemma allegory can help.
Explaining the prisoner’s dilemma
The prisoner’s dilemma is an example of game theory, which provides a framework for rational decision-making. (Bear with me here, the setup is a bit dense, but the payoff is a system for making good decisions.) The story goes that two criminals are arrested and confined in separate rooms.
The police have evidence to convict them on a lesser charge, but can’t prove the larger crime. The officer gives each prisoner the option to betray the other in exchange for a reduced charge.
The potential outcomes are as follows:
1. If both prisoners betray each other, they’re each imprisoned for two years;
2. If A betrays B and B stays silent, A is acquitted and B serves three years (and vice versa); and
3. If both remain silent, both serve the one-year lesser sentence.
Although Prisoner A probably wouldn’t develop a decision-making matrix in his cell, if he did it would look like this:
Prisoner A (a highly-rational criminal) knows he controls his own actions, but not his accomplice’s. He must make a decision based on his accomplice’s decision.
Prisoner A sums up the potential outcomes of staying silent versus betraying. If he stays silent, the outcomes add up to -4. If he betrays, they add up to -2. Thus, the rational prisoners will betray each other every time (assuming a one-time interaction without the ability to cooperate by playing multiple rounds of this game).
The prisoner’s dilemma and financial decisions
Many of my clients are emerging professionals who are building success and still have many years ahead of them. They have young families and are approaching their prime working years, but haven’t yet amassed enough wealth to retire on.
The goal for every client is to develop a plan that will succeed under multiple circumstances. For emerging professionals, their goals and dreams depend on their ability to stay healthy and go to work. For example, someone earning $100,000 for 25 more years will make $2.5 million without even considering raises and promotions.
If a life event prevents them from working, the finances must still succeed.
I recently advised a young professional, a single female at the start of a successful career. We discussed the philosophy of success under multiple circumstances and the issue of disability insurance arose.
Her employer provides strong group disability insurance, but even the best group disability will leave some exposure. And that coverage would protect her only so long as she stays with the employer.
She’s young and healthy now, but what if her health changed and then she couldn’t get insurance?
The prisoner’s dilemma helped her consider the possibilities.
She can decide to purchase disability insurance, but she can’t decide to stay healthy. Therefore, if she buys insurance and stays
healthy, that’s a slightly negative outcome because she could have saved the money. But if she bought insurance and got sick, she would be happy to have it.
On the other hand, if she didn’t get insurance and stayed healthy, she would have saved money. But if she didn’t have insurance and got sick, that would be a very bad outcome.
The decision-making matrix turned out something like this:
Thus, if she purchased insurance the total outcome was +3. If she didn’t get insurance the total outcome was -2. As a result, she determined it was a rational decision to protect her insurability as a young, healthy professional.
Thinking critically about financial decisions
These are the types of conversations we have with our clients. The choice to make one decision is a decision to not do something else.
When we consult with our clients on these important issues, we don’t just give our opinions. Instead, we measure one decision versus another and let them decide. Because we can’t predict the future, but we can prepare for it.
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Attorney Kyle Zwiren works with Financial Architects Inc., an independently-owned company located in Farmington Hills. Zwiren and his team serve attorneys and other professionals to help them design financial plans in line with their goals and based on optimal efficiency. He practiced law prior to becoming a Financial Architect and left the practice to follow his passion.
To talk to Zwiren about other topics featured in The Economic Blueprint, email him at kzwiren@financialarch.com or call him at 248-482-3622.
