Why Losing Hurts So Bad
It’s time for a pop quiz! There are only two questions so there’s no need to play sick and cut class. This will be quick and painless.
Question 1: Which do you choose?
A.) Get $900 for Sure
B.) 90% Chance to Get $1,000
Question 2: Which do you choose?
A.)Lose $900 for Sure
B.) 90% Chance to Lose $1,000
Having tested the Ballast team as well as some friends and family, there seems to be a pattern in the responses. Most people choose the sure thing when it comes to the opportunity to win money, but choose to gamble when facing a sure loss. This runs counter to everything I learned in my first economics class, which sketched out a “rational man” who made consistent decisions based on probability. Although the math is identical in both questions, we humans hate losing so much that we’re prepared to go against the math to avoid a loss. The thought of a loss hurts so bad, it is clear that I lied when I said the pop quiz would be painless.
Avoiding the risk of loss seems to be hard-wired into our DNA. Biologists can pose countless situations where risk aversion pays off; it pays to run away from a rustling bush that might be hiding a hungry tiger, even if you think it’s just the wind. After all, you only have one life to protect. It seems to me that risk aversion is hard-wired into mathematics as well. When you lose a small amount, it takes a relatively small gain to compensate. However, as the size of your loss grows, the gain needed to make it back to even grows faster. The table below shows why people act to avoid losses, even irrationally or to their overall detriment.
The questions in today’s quiz were borrowed from Dr. Daniel Kahneman, a psychologist who earned the 2002 Nobel Prize in Economics. His book, Thinking, Fast and Slow, outlines his prize-winning behavioral decision-making theories and shows how to determine how loss averse you are personally. Imagine a 50-50 gamble in which you stand to lose $10. What would you need to be able to win to make that bet attractive? The more you require, the more risk averse you are. Interestingly, as the stakes rise, most people require more compensation for their risk; one might want to win $15 to risk $10, but $160 to risk $100. This trend holds until the stakes reach levels that could be financially ruinous, when loss aversion skyrockets.
Putting on my financial planning cap, Dr. Kahneman’s book teaches me two things. First, as investors, our emotional aversion to loss can cause us to miss opportunities because our brains often take shortcuts and cause us to make irrational gut decisions. Once we recognize our loss aversion, we can slow down and let the deliberate decision-making system in our brain make a rational evaluation. Second, since we become extremely loss averse when we think the stakes could ruin us, it helps to have a plan that lets us know what we can afford to lose. Being comfortable with our cash flow and having an idea of where we stand can help us battle our loss aversion and make strong and unemotional decisions. We are always excited to search out this happy medium!