Risk Reward Heuristic

riskrewardindexThis post is based on a paper: “Ecologically Rational Choice and the Structure of the Environment”, that appeared in the Journal of Experimental Psychology: 2014, Vol. 143, No. 5. The authors are Timothy J. Pleskac and Ralph Hertwig. The paper is based on the idea that decision making theory has largely ignored the idea that risk and reward are tied together with payoff magnitudes signaling their probabilities.

How people should and do deal  with uncertainty is one of the most vexing problems in theorizing about choice. The researchers suggests a process that is inferential in nature and rests on the notion that probabilities can be approximated from statistical regularities that govern real-world gambles. In the environment there are typically multiple fallible indicators to guide your way. When some cues become unreliable or unavailable, the organism can exploit this redundancy by substituting or alternating between different cues. This is possible because of what Brunswik called the mutual substitutability or vicarious functioning of cues. It is these properties of intercue relationships and substitutability that Pleskac and Hertwig suggest offer a new perspective on how people make decisions under uncertainty. Under uncertainty, cues such as the payoffs associated with different courses of actions may be accessible, whereas other cues—in this case, the probability with which those payoffs occur—are not. This missing probability information has been problematic for choice theories as typically both payoffs and probabilities are used in determining the value of options and in choosing. However, if payoffs and probabilities are interrelated, then this ecological property can permit the decision maker to infer hidden or unknown probability distributions from the payoffs themselves, thus easing the problem of making decisions under uncertainty.

The authors conducted an ecological analysis of certain of life’s gambles, ranging from the domains of roulette and life insurance to scientific publications and artificial insemination. Across all domains, payoffs and probabilities proved intimately tied, with payoff magnitudes signaling their probabilities. In some cases, the constraints of the market result in these two core elements of choice being related via a power function; in other cases, other factors such as social norms appear to produce the inverse relationship between risks and rewards.  Thus, a person can gauge the probability of payoffs within a lottery by estimating the ratio of the cost of playing to the total amount of possible winnings. Pleskac and Hertwig call this shortcut the risk–reward heuristic,

In experiments the researchers conducted, participants used the size of the prize to infer the probability of winning. The evidence does not support a strong (error-free) form of the risk–reward heuristic. Nevertheless, the observed negative correlations between payoffs and inferred probabilities suggest that the risk–reward heuristic strongly anchors people’s regressed estimates. The risk–reward heuristic also offers an  explanation of why, by suggesting that aversion to ambiguity is (at least partly) due to an ecologically grounded belief that high payoffs have a low probability of occurring. Subjective expected utility theory implies that a decision maker’s subjective beliefs concerning the event in question are formed independently of the payoffs. The risk reward heuristic suggests that social and economic forces push the probability distributions toward a Pareto-efficient frontier, thus permitting ecologically smart choices based on inferences from the risk–reward heuristic. Thus, the structure of the environment can be exploited to turn uncertainty into risk or to at least reduce uncertainty.

Pleskac and Hertwig, unlike Brunswik, who often treated representative and systematic design as antagonistic tools, believe that there is a division of labor between them. For instance, if the goal is to evaluate competing choice models, then research is likely to rely on systematically designed stimuli that discriminate between them. If the goal is to understand how an organism functions and performs in an uncertain environment, then representative design is likely to be the method of choice. Employing representative and systematic designs as complimentary tools promises novel questions. For example, do violations of axioms of normative choice theories such as the sure thing principle, substitution axiom, and transitivity generalize to investigations
implementing representative designs, or are they restricted to the stimuli systematically designed to demonstrate them?

Pleskac and Hertwig suggest that the risk reward heuristic is one tool that empowers people to navigate uncertainty by inferring an unknown probability of a payoff from the magnitude of the payoff itself. These findings challenge the often reductionist approach of theories of decision making under risk and uncertainty, which seek to understand decision making by decomposing complex real-world risky decisions into choices between monetary lotteries that are defined
by the independent constructs of payoffs and probabilities. An adaptive view of rational choice, however, suggests that this is a questionable approach. In real environments, these two constructs are often not independent, and people appear to exploit their dependency.

The risk reward heuristic does seem to be something that people use. From what I can tell separating decisions under risk from decisions under uncertainty is a normative idea, not a descriptive one. However, medical decision making comes to my mind as an area where it is probably often not successful in exploiting the environment. In my opinion, it seems that people too often see the reward of being cured of cancer as one that should be matched up with the most risky or extreme procedure. The reward seems like it is winning the lottery in many cases, but the heuristic cannot erase the uncertainty. The marketplace or the ecology are not well enough established.