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Are You Logical When it Comes to Risk?
By JLP | April 5, 2007
I’m still reading James O’Shaughnessy’s Predicting the Markets of Tomorrow
Anyhow, in their experiment, they offered their participants the following two scenarios:
Scenario 1
Option A: a 100% chance of winning $50, or…
Option B: a 50% chance of winning $100 and a 50% chance of winning nothing
Which one would you choose?
Scenario 2
Option A: a 100% chance of losing $50, or…
Option B: a 50% chance of losing $100 and a 50% chance of losing nothing
Again, which one would you choose?
Mathematically the odds are the same in both scenarios. However, the professors found that the overwhelming majority of participants chose option A in Scenario 1 and option B in Scenario 2. As O’Shaughnessy says:
“…people are risk-averse when facing gains but risk-seeking when facing potential losses. When Tversky and Kahnerman manipulated the odds in each scenario, they found that generally, people consider losses twice as painful as gains, and will take on huge risks to avoid them. Conversely, they will take very little risk when seeking gains.”
Interesting…
Now, be HONEST,… which options would you have chosen?
Topics: Investing | 16 Comments »
April 5th, 2007 at 9:44 am
S1 – Option A
S2 – Option B
Generally, I find this to be true. One factor I could see changing this would be if you started to put pre-conditions such as “and it’s all the money you have in the world”, etc. That may influence my decision making. However, the experiment is a good one in that it demonstrates tendencies among us.
April 5th, 2007 at 10:45 am
S1 – B
S2 – B
I like to gamble I guess.
April 5th, 2007 at 10:57 am
I think I would do “A” for both.
Another interesting thought experiment to determine your risk-averseness is to do 1-in-100 chances of even odds at different values. E.g.
$1 guaranteed or 1-in-100 chance at $100?
$10 guaranteed or 1-in-100 chance at $1,000?
$100 guaranteed or 1-in-100 chance at $10,000?
$1,000 guaranteed or 1-in-100 chance at $100,000?
$10,000 guaranteed or 1-in-100 chance at $1,000,000?
…
etc.
Also do it for losses, i.e. lose a dollar or a 1-in-100 chance at losing $100. These are all “even bets”, i.e. there’s no mathematical/rational preference between them, but the usual trend is to be risk-seeking with lower dollar amounts and cross over to risk-averse at the higher dollar amounts.
Then go over and do it again with non-even bets. E.g., $10,000 or a 1-in-50 chance at $1,000,000. In this case, the mathematics are clear which is the better choice (higher expected outcome) but the typical person would choose the guaranteed $10k.
Economists love the show Deal or No Deal because it tests these ideas in a fairly pure way. There is actual money at stake, unlike in these thought experiments.
April 5th, 2007 at 11:17 am
Predictably, I went for A then B, although I did realise that the odds are the same.
April 5th, 2007 at 1:23 pm
I would pick B for both. However if the #s were $50,000 for A, and $100k or 0 for B, I would pick A for S1, and B for S2. With that much at stake, I would make sure I walked away with money. However, if I had the chance not to owe any versus, owing $50k for sure, I’d roll the dice.
I realize the odds are the same, but the larger numbers change how I would act.
April 5th, 2007 at 2:20 pm
I’m not a big risk taker and I also found this true.
1. A
2. B
-New2TheRatRace
April 5th, 2007 at 7:07 pm
I went for A, then B as well. I would consider myself risk adverse. It looks like the commentors are backing up the study!
April 6th, 2007 at 1:04 am
I picked A/B.
However if I only had $100 total (or some fairly small amount) then I would certainly pick A for the second one as well.
April 6th, 2007 at 8:19 am
(a) $1,000,000 guaranteed or (b) 1-in-1000 chance at $1,000,000,000?
This illustrates to me why I’m uncomfortable with some of the conclusions that are made from these scenarios. Mathematically, the expected value is the same, but that is not all of the story.
In finance, risk also entails the variance of outcomes. In (b) above, the difference between $0 (99.9% chance) and $1,000,000,000 (0.1% chance) is enormous, making it a very “risky” gamble.
Practically speaking, I’d rather take a known $1M that I can manage carefully and retire on, than almost certainly gain nothing at all.
April 6th, 2007 at 10:28 am
Ptomkin,
I see your point. However, it’s in the small day-to-day decisions where people make mistakes that compound on each other. In other words, most people don’t get to choose between $1 million and $1 billion.
April 6th, 2007 at 11:19 am
I picked A and A for both. I would be very interested to see if the article that the quote came from had any analysis or possible fix for this behaviour than just the findings alone.
My Own Millions Blog
April 6th, 2007 at 11:42 am
test
April 6th, 2007 at 12:23 pm
I read about this recently in Smart Money Magazine. It’s a great study and I think this is the kind of thing our school system needs to get more involved in so we can raise children who have more financial literacy.
http://everincreasingwealth.blogspot.com
http://20challenge.blogspot.com
April 6th, 2007 at 4:41 pm
I picked ‘A’ for both.
April 7th, 2007 at 6:19 am
The expected values being the same only makes them the same if you get to repeat them multiple times. If you are not repeating the experiment, then it doesn’t make sense to look at the expected value as its not the solution to the question being posed.
April 14th, 2007 at 9:16 am
[...] Money Smart Life has Would You Settle For $500K Or Go For A Million Dollars? is all about getting to know what your financial risk profile is, as illustrated by the game show “Deal or No Deal.” Similarly, All Financial Matters asks Are You Logical When it Comes to Risk? I took JLP’s test and found I voted like everybody else did, when it came to taking a chance! [...]