The Allais Paradox: Why Was Certainty So Attractive?

To explain what the Allais Paradox is, let me quote from a 2010 Wired article:

It’s known as the Allais Paradox, and it was first outlined in a 1953 Econometrica article. Here’s an example of the paradox:

Suppose somebody offered you a choice between two different vacations. Vacation number one gives you a 50 percent chance of winning a three-week tour of England, France and Italy. Vacation number two offers you a one-week tour of England for sure.

Not surprisingly, the vast majority of people (typically over 80 percent) prefer the one-week tour of England. We almost always choose certainty over risk, and are willing to trade two weeks of vacation for the guarantee of a one-week vacation. A sure thing just seems better than a gamble that might leave us with nothing. But how about this wager:

Vacation number one offers you a 5 percent chance of winning a three week tour of England, France and Italy. Vacation number two gives you a 10 percent chance of winning a one week tour of England.

In this case, most people choose the three-week trip. We figure both vacations are unlikely to happen, so we might as well go for broke on the grand European tour. (People act the same way with lotteries: we typically buy the ticket for the biggest possible prize, regardless of the odds.)

Allais presciently realized that this very popular set of decisions – almost everybody made them – violated the rational assumptions of economics. Instead of making decisions that could be predicted by a few mathematical equations, people acted with frustrating inconsistency. After all, both questions involve 50 percent reductions in probability (from 100 percent to 50 percent, and from 10 percent to 5 percent), and yet generated completely opposite responses. Our choices seemed incoherent.

What Allais Paradox shows us is that we prefer certainty of payoffs above our own welfare. Uncertainty, either in life or in investing unsettles us.

From the FT:

The two most likely outcomes are: (1) that the Fed leaves rates on hold while keeping a rate rise on the table in 2015; or (2) that it raises rates but emphasises how gradual subsequent tightening will be.

In the first scenario — a “hawkish hold” in market lexicon — the FOMC would keep rates at near-zero but signal that a possible move in October or (more likely) December remains on the cards.

The second scenario — a “dovish hike” — involves lifting rates by a quarter-point but suggesting that no more moves will come in 2015, and that subsequent increases will be very gradual.

In the light of what’s happening today with the FOMC, and throwing my two cents in, I would just say this:

One, that uncertainty costs.

Secondly, that although expectations can be managed in the short run, in the long run, only credible, structural changes matter. Keirkegaard said, “Life can be understood backward, but … it must be lived forward”.

Although good decisions are made studying historical facts, or as ‘they’ said, data dependent, wise decisions must foresee beyond the numbers and into the consequences of today’s events. Drop the “data dependent” phrase, it is obvious there is more to it than that.

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