Our tendency to underestimate the variance - or noise - in business

πŸ’Ž Our tendency to underestimate the variance – or noise – in business

In a well-run insurance company, if you randomly selected two qualified underwriters or claims adjusters, how different would you expect their estimates for the same case to be? Specifically, what would be the difference between the two estimates, as a percentage of their average?

We asked numerous executives in the company for their answers, and in subsequent years, we have obtained estimates from a wide variety of people in different professions. Surprisingly, one answer is clearly more popular than all others. Most executives of the insurΒ­ance company guessed 10% or less.Β  When we asked 828 CEOs and senior executives from a variety of industries how much variation they expected to find in similar expert judgments, 10% was also the median answer and the most frequent one (the second most popular was 15%). A 10% difference would mean, for instance, that one of the two underwriters set a premium of $9,500 while the other quoted $10,500. Not a negligible difference, but one that an organization can be expected to tolerate.

Our noise audit found much greater differences. By our measure. the median difference in underwriting was 55%, about five times as large as was expected by most people, including the company’s executives.

Excerpt from: Noise: A flaw in human judgement by Daniel Kahneman, Olivier Sibony and Cass R. Sunstein

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