Skewing the odds

Everyone understands that if the odds of a coin toss are 50/50, we might as well flip that coin. But what if those odds aren’t so clear?

In a groundbreaking piece of research, economist Daniel Kahnemann found that we consistently disregard the actual outcomes involved in winning and losing. Specifically, we feel the pain of losing approximately 2.25 times more than the satisfaction of winning. Because we feel a loss more acutely, we unconsciously skew our decision-making to “correct” the odds. So if that coin flip decides a win-or-lose proposition with some real consequences, most of us prefer not to risk it.

He called this quirk of human nature loss aversion. It became one of the first principles of behavioral economics, which rejects a fundamental tenet of classical economics: that individuals act rationally in their own best interests. As it turns out, we act irrationally, on a consistent basis, in all kinds of ways – often directly against our interests.

Behavioral issues can have a dramatic effect on your finances. Investing is all about balancing risk and reward, and financial math can tell you precisely what that balance should be for a given goal. But if you gauge that balance by “feel,” you’ll shy away from an appropriate level of risk by a factor of more than two. Because risk drives reward, over time your investments will earn much less than they should have.

This doesn’t just happen with money, but with all kinds of risk. One business-school study found that even some of the most expert decision-makers, professional football coaches, often get it wrong.

In an analysis of all fourth-down situations across two NFL seasons, statistics clearly showed that “going for it” instead of punting or trying a field goal was usually the right call in terms of maximizing points scored. But even accounting for situational factors, coaches tended to be kick the ball away far more often than was in their teams’ best interests.

Why did these hard-nosed veterans of the game act so timidly? The author theorizes that loss aversion was in play. A win is a win, as the saying goes. Everyone celebrates and moves on. With a loss, however, that critical fourth down is replayed and debated, fingers are pointed, and the coach’s future may even be in doubt. He might well understand the odds. But the collective loss aversion of the fans and owners is powerful enough to influence his decisions.

No one is sure exactly why our brains work the way they do. But we can at least be aware of some of our underlying irrationality. And with this understanding, we can skew our decisions away from these primeval behaviors, and toward the economic rationality that we need to prosper in a complex, rational world.

Image courtesy Nicu Buculei via Flickr Creative Commons