Understanding decision-making: Inherent risk preferences

When trading off a potential loss with a potential gain, individuals behave as if losses count more than gains.

Setting the Reference Point

There are multiple values that a reference point can take. Determining which reference point individuals use is both an art and a science, and an active area of research.

The existing evidence suggests three factors that determine the reference point.

1. Status quo and security level: Individuals tend to look for the alternative with the “best” worst outcome. If this outcome is better than the current situation, they tend to update the reference point to this security level. If it is negative or the company has the option to do nothing and stay as is, it tends to keep the reference point at the status quo.
2. Past outcomes and future expectations: At what price would you be neither happy nor unhappy about selling stock? Existing research shows that the reference point is mostly based on the purchase price and on the most current price.
3. Social comparison: Suppose your previous end-of-year bonus was $10,000, and this year there is talk of a bonus of $15,000. Would your reference point be $10,000, $15,000 or somewhere in between? You might be happy after receiving a bonus of $15,000 because it was higher than last year’s and in line with your expectations. Your happiness, however, would soon evaporate if you learned that some of your peers had received $20,000!

This example also illustrates that reference points can change quite rapidly, and that it is difficult to change the reference points at will.

Of course, it is critical with whom you choose to compare. Olympic bronze medalists are found to be happier than silver medalists, at least in the short run, because the silver compares with the athlete ahead, whereas the bronze compares with the athlete behind.1

Also read: Take 5: How fear influences our decisions

Practical Implications

Loss aversion and decision weights make us act in a risk-avoiding way in some circumstances and in a risk-seeking way in others. Risk aversion keeps us away from financial disaster. Too much risk aversion, however, also implies that we will not get very far in the long run. For example, once we discover a good business opportunity or a profitable investment strategy, we may avoid doubling down, because increasing the stakes produces apprehension. Keeping their foot on the gas pedal for good opportunities is what differentiates great investors such as Warren Buffet from others.

How about seeking risks? Betting on long shots and buying lottery tickets is fun and exciting, but it is profitable for only a minority of lucky winners. As probability becomes small, the premiums we pay may become very large. And small odds mean the premiums will not be large in absolute terms (e.g., the small cost of a lottery ticket or an overpriced insurance product).

The most worrisome pattern is being risk-seeking for losses of high probability. This induces a tendency to double down when one is “in the hole” and can easily snowball into larger losses. The following are some examples of the escalation of commitment created by the tendency to take risks to escape a sure loss:

•     A first-year graduate student invested an inheritance from his grandparents in a technology stock. After buying at $1.30 a share, the company appeared to tank, and shares dropped to $30. He refused to sell, believing things would turn around enough to allow him to get back what he had originally paid. In fact, it got worse! But he still held on to the stock. This behavior is called the disposition effect and is common among stock investors.
•     People don’t like “to pay” the sure cost of reading instructions on how to assemble or install things. They prefer to take chances and fiddle with them, often with the result of spending much more time or, worse, breaking something or getting injured.

Notice that our risk-seeking attitude for losses may drag us into a chain of mistakes. Instead of acknowledging a failure, we double down, and the problem gets bigger and bigger until it erodes our own wealth and that of others involved. Before entering into a venture, a good idea may be to set limits to your losses in advance and find some way to commit to this pre-established exiting rule. For example, give instructions to your broker to sell when a given stock reaches a certain loss level.

Or, to say it another way: If you go hiking, set a turnaround time.

Summary

Individuals are rarely risk-neutral or consistently risk-averse. Instead, their risk attitudes can vary quite a bit depending on what they perceive to be a gain or a loss relative to a reference point, and on whether the situation involves small or large probabilities.

Prospect theory is a framework that organizes these observations, and it consists of three effects:

• Reference point: A baseline outcome that gives an intuitive sense of gains and losses. The reference point may change, and what used to appear as a large gain may later by seen as a small one or even a loss.
• Loss aversion: Losses count more than gains.
• Decision weights: Small probabilities are magnified, and high probabilities are reduced.

The preceding is drawn from the technical note Behavioral Risk Preferences (Darden Business Publishing) by Manel Baucells.