One stereotypical example quoted in behavioural finance is about our irrational risk aversion. Look at the Nobel Prize winning Kahneman
“In my classes, I say: ‘I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?’
“People want more than $20 before it is acceptable. And now I’ve been doing the same thing with executives or very rich people, asking about tossing a coin and losing $10,000 if it’s tails. And they want $20,000 before they’ll take the gamble.”
In other words, we’re willing to leave a lot of money on the table to avoid the possibility of losing.
That is precisely what it is not.
The correct question to ask, if you were asked for this gamble is:
“How many chances do I get?”
If the chances are infinite, my answer would be $11. (Assuming it’s a fair coin). I have to have some capital – say $1,000 – to counter a really bad run, but in the end I’ll end up winning and winning big money.
If the chances are 10, then I have to be willing to lose $100 (max 10 losses), and to be paid for the risk I might demand $50 more, so I want $15.
If you’re going to tell me I have to be on it exactly once, then I’ll still want to get reasonably well paid, and if I’m going to lose $10 then I better gain $20 at least – I would actually probe to find out what’s the maximum you would pay and if it’s not attractive I won’t bother.
The concept of loss aversion is one thing, but you can’t look at it as a silo. Typically our choices are one-shots. How many careers can you have? So you choose your profession based on what you think will make sense, not on probabilities. In fact, given that most startups fail, no one should ever choose entrepreneurship at all – but we do, because we have the ability to influence what we create and therefore it makes complete rational sense to try and to not be discouraged by probabilities.
Probabilities only make sense if you take enough chances. When you don’t have enough chances, the probability of success and the odds you get are about as useful, in your decision making, as wood chips.
Here’s another one often quoted:
In an oft-cited experiment, the psychologists asked a group of subjects to imagine the outbreak of an unusual disease, expected to kill 600 people, and to choose between two public health programs to combat it.
Program A, the subjects were told, had a 100 percent chance of saving 200 lives. Program B had a one-third chance of saving 600 lives and a two-thirds probability of saving no lives.
Offered this choice, most of the subjects preferred certainty, selecting Program A.
But when the identical outcomes were framed in terms of lives lost, the subjects behaved differently. Informed that if Program A were adopted, 400 people would die, while Program B carried a one-third probability that no one would die and a two-thirds probability that 600 people would die, most subjects chose the less-certain alternative.
This is mentioned as “Oh If I framed the argument differently, people make different decisions”.
But it’s not that at all. That’s not why people made decisions differently.
It’s the fact that you had one chance. Just one.
If I were asked the same thing, I’d still chose Program A in the first instance and take the chance that I could potentially save the rest. Because I have just one chance, I bet on the fact that the probability would simply not work, and that I can change the outcome.
And I’d choose Program B in the second instance because, again, I would rather not see 400 people surely die, because there’s a chance I can save them and screw up the probability metric.
People don’t see probabilities as applying to them if they can somehow influence the outcome.
If I were given 100,000 such bets, then I would use the probabilities to make the decision. Otherwise the probability is useless, other than to add all sorts of eye candy and long articles and big books on behavioural finance.
But in reality, if you ask “How many chances do I get?” your decisions will completely change.
If you’re going with probabilities, then you better make sure you have enough bets to make, and that you can make them. Meaning, diversify, put your eggs into different baskets, and make sure that a loss in any one doesn’t put you out of business.
If you have the ability to influence the outcome of your investing – like Buffett does by getting on the board of the companies he buys – don’t bother with generic probabilities, though you must quote them when you want people to adore you.
I’ve been trying to build my life so I get more chances, more doors to open. Because luck plays a huge role in any success. But in many cases, you find sitting ducks – a fire-sale that you know you can turn around, a great business idea where others don’t seem to be looking, or some such. These shouldn’t be evaluated using probabilities alone – otherwise I will always find myself denying there is money to be made, using the simple argument that if there was, someone else would have made it.