Actuarial Fallacies

Just some light stuff, to chew the cud during holidays...

A good friend tells you that a certain 'John Nevermet' is an introverted professional and is either an actuary or a salesman.

Which one do you think John most probably is?

If your first thought was: an actuary, congratulations(!), you just got caught in what is called a classical

Thinking Trap

Most people - not actuaries of course ;-) - are tempted to think John is almost certainly an actuary.On the other hand, they think of a salesman as 'outgoing', 'extrovert' or maybe 'pushy', but certainly not as 'introvert'. Wrapped up : John is an actuary....

Sorry, but - as you know - this logic conclusion is definitely wrong. It neglects the fact that salesmen outnumber actuaries at most 100 to 1. Before you would even start to consider John's character, you should have concluded that even when all the actuaries were introvert, there would only be a small 1% probability that John is actually an actuary (only in the unlikely case that less than 1% of the salesmen would be introvert, this option would be logically to consider).

Top 10 Thinking Traps
This foregoing simple example is just one of the fabulous Top 10 Thinking Traps Exposed by Luciano Passuello.

On his blog Litemind, Luciano explains in a 5 minute 'must read' called 'How to Foolproof Your Mind' the next interesting and most harmful Thinking Traps, including suggestions on how to avoid each one of them. :

1. Anchoring Trap: Over-Relying on First Thoughts
   Your starting point can heavily bias your thinking
   
2. Status Quo Trap: Keeping on Keeping On
   We tend to repeat established behaviors
   
3. Sunk Cost Trap: Protecting Earlier Choices
   Sunk cost shouldn’t influence a decision, but it does
   
4. Confirmation Trap: Seeing What You Want to See
   Being less critical of arguments that support our initial ideas
5. Incomplete Information Trap: Review Your Assumptions
   Overlooking a simple data element can mislead our intuition
   
6. Conformity Trap: Everybody Else Is Doing It
   Other people’s actions do heavily influence ours
   
7. Illusion of Control Trap: Shooting in the Dark
   The tendency to overestimate our personal control
8. Coincidence Trap: We Suck at Probabilities
   A “miracle” is - given enough attempts - possible!
   
9. Recall Trap: Not All Memories Are Created Equal
   “Special events” have the potential to distort our thinking
   
10. Superiority Trap: The Average is Above Average
    People have much inflated views of themselves
    

Thinking traps are a special form of fallacies.

Example
A nice and triggering example of a composition fallacy is:
I fit into my shirt... My shirt fits into my luggage...
Therefore I fit in my luggage...

Can you tell what's going wrong here?
Yes? Then get ready for the next fallacy phase.

Although there a complete list of fallacies, another new interesting subset could be defined as 'Actuarial Fallacies'....

Actuarial Fallacies
Except for a 1988 homonymous, humorous intended, nevertheless still actual and relevant document by Charles L. McClenahan, nothing much has been published on actuarial fallacies.

Apparently fallacies are not an issue on the Actuarial Globe.

Therefore, I'll confine my remarks to a few actuarial events, of which each one could easily be nominated for the fictional 'Grand Actuarial Fallacy Prize':

1. Longevity risk can be easily managed
   Longevity slowly but steadily increases. It's not a yearly smashing or impressing risk, but over the years it has the characteristics of a killing sniper: when you finally discover the accumulated longevity loss after a few years, it's almost too late to handle and take appropriate measures.
   
   Actuaries could have foreseen a few decades ago that the average life span would keep rising and adequate measures had to be taken at once. Instead, actuaries failed to catch the implications of the rise in longevity and were caught by the proverbial 'boiling frog effect'. In short: actuaries failed to act in time....
   
   
2. Stocks are a hedge against fixed-income liabilities
   Already in 1994 in a document called 'On The Risk of Stocks in the Long Run', nobody else than Zvi Bodie already proved that stocks are not a hedge against fixed-income liabilities even in the long run.
   
   
3. Credit Crisis
   Actuaries have failed in foreseeing the credit crisis. We have greatly underestimated the developments and put our head in the sand. We have trusted business plans promising ROEs of 15% and more.Read more in Actuary-Info's : "Wir haben es nicht gewußt!"
   
   
4. VAR Model
   As an article in The Actuary shows, we got intimidated and overruled by the 'magic' quants with their Value at Risk (VaR) models. We did and do know better as actuaries, but missed the boat. Actuaries should be more than professionally trained in giving 'push back'.
   
   
5. The relationship between risk and return
   As we know this risk-return relationship is central to strategy research and practice.
   
   In measuring risk as the variance of a series of accounting-based returns, Bowman obtained the puzzling result of a negative association between risk and mean return.The expected positive association between risk and return turns out to be elusive.
   
   Henkel explains in two must-read articles 'Risk-Return Fallacy' (2000) and The Risk-Return Paradox for Strategic Management: Disentangling True and Spurious Effects the problems and solutions in this field.
   
   Instead of only following what's happening on the other side of the balance sheet, actuaries should mobilize themselves and add some new insights!
   
   Asset Actuaries, please rise!
   
   
   Es ist nicht genug zu wissen, man muss auch anwenden
   - Johann Wolfgang von Goethe -
   
   

Now that we've unmasked several fallacies, in special the 'introvert actuary fallacy', let's conclude our fallacy course with a 'lessons learned?' actuarial anecdote:

Why it's better to work with an imperfect actuary
We all know: A perfect actuary draws perfect conclusions form perfect datasets.

Then of course : A perfect actuary certainly draws "wrong conclusions" from imperfect data.

It's a fact that the data are always imperfect.

So that we can conclude that there is at least a small chance that an imperfect actuary may draw the right conclusion.


That's why it's better to work with an imperfect actuary.

Client Quote
As we know, clients are always right. Remarkably, the next client quote seems to stress the mentioned successful outcome of the imperfect actuary:
I once had an actuary tell me that, because the future is uncertain, his numbers were almost certainly wrong, but he believed they were less wrong than guessing outcomes with no analysis.

You think - by now - you know everything about fallacies?
Well, test it by taking the next fallacy Quiz:

How logical are you?

Success!

Original source :
The November 1983 Random Sampler article Actuarial Fallacies