What is Risk?

We people have a funny way of perceiving risk. We tend to be “loss averse.” Which is to say that we worry more about losing than we look forward to winning. Losses have twice as powerful a psychological effect on us than gains. A person who loses Rs. 100 loses more satisfaction than the satisfaction gained by another person who wins Rs. 100.

All of what I just said are results of a host of fascinating studies on risk perception, done over the last three decades. Daniel Kahneman, a Princeton professor, has been at the forefront on several of these. Such studies have profoundly impacted the way products and services have been marketed over the years.

Loss aversion is used to explain why we put a higher value on a good that we own compared to an identical good that we do not own. The scientific term for this is ‘endowment effect.’ It’s also used to explain what’s called ‘sunk cost fallacy’ – when we make irrational decisions to put in more (good) money to recover (bad) money that has been lost.

Consider this example.

If you had to pick one of two choices: (A) a guaranteed prize of $1000 OR (B) Flip of a coin to win $2500 if heads or win $0 if tails. What would you pick?

Now, if you had to choose between (C) a guaranteed loss of $1000 OR (D) Flip of a coin to lose $2,500 if heads or lose $0 if tails. What would you pick?

The expected outcomes are $1000 (gain) for choice A and (50% of $2500 =) $1250 (gain) for choice B. Similarly, the expected outcomes are $1000 (loss) for choice C and $1,250 (loss) for choice D.

In studies, it turns out that a majority of people picked (A) and (D) – both irrational and inferior choices. That’s because we humans are wired to prefer certainty in gains and to *not prefer* guaranteed losses. This is why fixed-income funds are popular. And why life insurance premiums are bundled along with recurring deposits, and sold as ‘savings’ plans.

Another example.

Teachers at Chicago public schools were split into two groups. One received bonuses (8% of salary) at the BEGINNING of the year. This group was told that the bonuses would be taken back if they did not meet goals. The other group was told that they would be paid bonuses (same 8% of salary) if they met goals, by the end of the year . The group that received bonuses at the beginning of the year outperformed the other significantly. Why? They went the extra mile to achieve their goals so they did not have pay back the money. Once received, paying back was perceived as a “loss.” Interesting!

So, the next time you make a decision, watch yourself closely to see how much your loss aversion is influencing you. You might be surprised at what you find.

I’m now reading Daniel Kahneman’s latest book, Thinking, Fast and Slow, perhaps a topic for another blog post some day. Cheers.

  • http://goingbeyondthepages.wordpress.com Jas

    Interesting indeed and very timely for me too :)