Risk Versus Reward

Psychologists have uncovered a surprising number of idiosyncrasies from making the soundest choice in many situations. These lapses explain some of the mysterious up and downdrafts that can lift and lower stock prices. Understanding them can make successful investing easier. The most important findings arise from answers to a pair of questions.

The first: If faced with the prospect of two possible gains, which would you choose?

  • A 100% chance to win $3000.
  • An 80% chance to win $4000.

Asked this question, most people choose the guaranteed $3000, even though the second choice has higher value according to probability theory. The value is determined by multiplying the second chance of winning, or 80%, by the $4000 the winner stands to gain (80% of $4000 is $3200). So in the long run you come out ahead by making the second choice consistently. Most people are bothered by the 20% chance of getting nothing in the second choice, which tells psychologists what stock market theorists knew all along: That investors in general prize certainty and abhor risk.

It’s not that simple, however. When people are confronted with prospective losses, quirky psychology turns them into riverboat gamblers. That fresh discovery became clear from another question. Which would you choose?

  • A certain loss of $3000.
  • An 80% chance of losing $4000 and a 20% chance of losing nothing.

Most people will gamble on the second choice, which offers a 20% chance of going unscathed, even though it is risker (again, 80% of $4000 is $3200). Because people’s horror of losses exceeds even their aversion to risks, they are willing to take risks – even bad risks. Contrary to what’s been believed, risk aversion is not always the guiding light of decision making.

To measure just how deep the fear of loss runs, psychologists follow up this pair of questions with another. Students were invited to wager on a hypothetical coin toss: Heads you win $150; tails you lose $100. Though the potential payoff is 1½ times the possible loss, most students refuse to bet.

How can otherwise rational people act so unwisely in the face of promising moneymaking opportunities? Despite the outsize reward for taking this risk, the researchers say, most people are put off by the 50% chance of losing. Loss aversion is a surprisingly powerful emotion. So great, in fact, that it keeps people from accepting good bets, both in coin flipping and in selecting stocks.

. . . John J. Curran, Investors’ Guide (1987)