We are, on the other hand, extremely averse to loss.
But now imagine the inverse. You can either lose your $3,000 for certain, or you can risk losing $4,000 instead, but with a 20 percent chance of not losing anything. That 20 percent is starting to look much more attractive for most of us. And the decision is more likely to be one we’ll sweat over.
(For those who dislike number-crunching, I will point out that the choice we expect most people to make in each case is, statistically, wrong. On the receiving end, you have an 80 percent chance of winning $4,000, so the mathematically expected benefit of the second option is $3,200. In the losing scenario, an 80 percent chance of losing $4,000 yields an expected loss of $3,200, so the rational course is to take the certain $3,000 loss.)
This is exactly the sort of question posed by Daniel Kahneman and Amos Tversky in their well-known 1979 study. Prospect theory, as developed by Kahneman and Tversky, suggests that in most cases, people are risk-averse when it comes to gains, but risk-inclined when that risk might prevent losses. More subjectively, it feels almost twice as bad to lose $100 as it feels good to win the same amount.
Being wary of loss is understandable, and not necessarily a problem. Some losses are too big to withstand, while the costs of avoiding them are tolerable. Buying fire insurance on your house, for example, is likely to be a losing proposition. Few houses have fires, and not every fire is catastrophic. But the cost of fire insurance is tolerable, while, for most people, the cost of replacing an uninsured home is not.
Still, we can make better choices if we understand why we are inclined to make the decisions we make.
As an investor, you may eventually face a steadily failing stock. Recognizing the failure early and getting rid of the investment can mitigate your losses. But selling comes at the cost of admitting that the stock is not likely to recover. You might be more inclined to cling to the unlikely prospect that you won’t lose anything than to accept your loss early, even though doing so probably will minimize the damage.
Knowing this, it is wise to make some decisions before emotions can get in the way. For example, setting a maximum acceptable loss when you first buy a stock will let you decide how much loss you can stand with a cool head, when the loss is purely hypothetical. Should the worst happen, the emotional bump will still be there, but you won’t make your losses worse by clinging to risk in the faint hope of a return. (Or you can do as we typically do, by diversifying your portfolio so much – through mutual fundsor other mechanisms – that even a total loss on an individual stock position is acceptable.)
It is also important to consider what prospect theory calls “framing,” or the way a problem is presented. And the decision involved may not always be a strictly financial one.
A study published in the New England Journal of Medicine examined the importance of framing in a medical context. Researchers framed the exact same data about comparative mortality rates two different ways when offering lung cancer patients the choice between surgery and radiation. When framed in terms of life (surgery carries a 90 percent immediate survival rate, and a 34 percent five-year rate; radiation offers 100 percent and 22 percent), patients overwhelmingly chose surgery. However, when the same data were reframed as mortality rates, (i.e. 10 percent of patients die during surgery, etc.), the majority chose radiation.
Comparing the two frames side by side makes it clear that not only are they precisely the same choice, but that surgery offers the better overall chance for survival. But most people do not tend to reframe a question when the original way it is presented is reasonable. This side-by-side comparison happens seldom in real life.
Clearly, paying attention to how questions are framed can be crucial for making rational and sound decisions. It can also put you on your guard against tactics used by everyone from advertisers to politicians in presenting choices a certain way.
Everybody’s perception of risk is different. Some people find skiing too risky; others enjoy sky-diving. Some people will ride an airplane, but not a motorcycle, while some people do the reverse. Some people play the lottery regularly. Others (like me) find it not worth the time, let alone the money it will nearly always cost. What we consider “too risky” and why comes from a variety of factors, some rational, some less.
Risk is an unavoidable part of life. Understanding how we react to risk can help us make life more rewarding.
Larry M. Elkin, CPA, CFP®, is president of Palisades Hudson Financial Group a fee-only financial planning firm heiadquartered in Scarsdale, NY. It offers estate planning, insurance consulting, trust planning, cross-border planning, businessvaluation, family office and business management, executive financial planning, and tax services. Its sister firm, Palisades Hudson Asset Management, is an independent investment advisor with about $950 million under management.