Let’s start with a question. You’re offered the chance to take part in a little bet. A fair coin will be tossed. If you win, you’ll receive R100. If you lose, you need to give up R100. Would you take up the bet?
Let’s change it up a bit. You still need to pay R100 if you lose the toss, but what is the minimum amount you would need to win in order to make the bet attractive?
The most common answer is somewhere between R200 and R250. This implies that individuals feel losses 2–2,5 times more than they feel gains.
What exactly am I trying to say?
Think about a rugby game. When the Springboks are 7 points ahead of their opponents, it doesn’t seem like that much of a lead, does it? It’s only one try. However, if the Springboks are trailing by 7 points, it feels like a huge setback (even though it’s still only one try).
Nobel Prize-winning economist Maurice Allais contextualised this anomaly by designing different choice problems to show inconsistencies in individual’s choices. By inconsistency, I mean that the choice we make is often not the one that has the highest expected outcome.
Let’s look at a mathematical representation of this and get the left-hand side of our brain working. You have to choose between:
(a) 100% probability of R1 million, or
(b) 89% probability of R1 million, 1% probability of R0, 10% probability of R5 million
(c) 89% of R0, 11% of R1 million, or
(d) 90% of R0, 10% of R5 million
Most people choose (a) and (d), but if you had to go work out the expected outcome, that is, utility, you’d find that the highest outcomes lie with (b) and (c).
Being loss-averse, we see option (b) has a probability of winning nothing, which seems entirely unappealing. We therefore select option (a) as we sleep better at night when we pick the certainty of winning R1 million, than the risk of winning nothing (even though we could potentially win R5 million). When comparing (c) and (d) to one another we tend to purely focus on the fact that if we were to lose, we’d lose more with option (d) and entirely neglect the potential up-side of option (c).
We feel losses more strongly than the equivalent gain and owing to this; we sometimes make decisions that aren’t entirely rational.
Have I convinced you yet?
If not, I’ll try again next time … with a picture.
Author: Gizelle Willows CA(SA)