In your life, you have to make a lot of decisions. Most of the time, there are uncertain factors in your decisions, because they have to do with the future. For example:
- Shall I buy insurance for my new, expensive bicycle?
- At what time do I leave to be on time for my appointment?
- Do we go left or right here?
Later on, you will sometimes look back at such decisions. It is very human to look at the result to determine whether the decision was good.
- My bicycle has been stolen! I should have bought insurance.
- It’s good that I left early, because the train I took had a huge delay.
- We went left as usual, but there was an accident on that route! We should have gone right instead.
Let’s look at this a bit closer. Is this a good way to judge your decisions?
The bicycle insurance. Let’s say your new bicycle costs 1,500 euros, half of your monthly salary. That is a lot of money. An insurance against theft and damage sounds like a good idea.
Of course, if you know beforehand that your bicycle is going to be stolen, the correct decision is to take the insurance. But you cannot know this. The best you can do, is to estimate the probability of theft. Maybe the local police has statistics which indicate that the risk of theft of expensive bicycles is 10% in the first year. Let’s use that number: 10% chance of theft.
If the insurance costs 1 euro for 1 year, most people would take this insurance. And if it costs 1000 euros for 1 year, most people wouldn’t. There is no need for fancy calculations here – people instinctively know that the former is a good deal and the latter is a bad deal.
Somewhere between 1 and 1000 is the right price for this insurance. In this case, it’s a simple calculation: the risk of theft multiplied by the price of the bicycle. So 10% x 1500 euros = 150 euros. *
The right way of judging your decision, is to compare the actual price to the right price. The wrong way is to use the result of the decision: has my bicycle been stolen?
Assuming a 10% chance of theft, buying insurance for 1 euro is a good decision, even if your bicycle is never stolen. And buying insurance for 1000 euros is a bad decision, even if your bicycle is actually stolen.
So, next time you are wondering whether a decision you made in the past was a good decision, remember the information you had at the time you made the decision instead of looking at the result, and judge based on that.
*) I’m looking at it purely financially, ignoring any emotional factors like loss aversion here.