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Risk and Loss Aversion

Risk and Loss Aversion

Under a risk-reward rubric, most people are averse to risk — even to the pointwhere they will forego a coin toss for $1 at even money, playing liars poker for adinner check, or drawing lots to determine who’s on top.  Most people’s decisionsclearly demonstrate that they prefer a certain positive outcome over a range ofoutcomes, even if the expected values are identical.  On the other hand, when a lossis certain, a decision with outcomes having similar expected values will get adifferent response if the outcome is defined in terms of risk than it will whenexpressed in terms of loss.

Captain Rob is directing five hundred men in retreat.  If he directs them to gothrough the valley, there is a 20% chance they will be ambushed by anoverwhelming force.  If he directs them to cross the river, they will with nearcertainty loose one hundred men to hypothermia.  Which path should the Captainchoose?  While statistically equal, most will choose the odds rather than thecertainty.  The odds can swing both ways – and psychological probability rarelyconforms with statistical probability.  As an example, the lottery ticket in yourpocket certainly has a much better chance of winning than the chance dictated byprobability theory, simply by virtue of the fact that you own it.  We believe that wecan manage and domesticate probability; we don’t have to accept it.

The biases demonstrated by our use of heuristics come under a number of differentclasses, of these, decision making biases, probability and belief biases, social biases,and memory error biases are the main categories.  The specific biases I have beenable to identify are well over one hundred.  As financial professionals, the ones thatget us in trouble are typically decision making and probability biases.

Following are some biases that I have seen produce real problems:

  • Authority bias is altering your perception of someone based upon thesubjective opinion of another authority figure, boss, or expert.
  • Availability cascade is a self-reinforcing process where collective beliefsgain credibility through repetition. (Greater risk, terrorism or influenza?).
  • Confirmation bias is interpreting and manipulating data in ways thatconfirm what you already believe.  (Using data the way a drunk uses alamppost – for support rather than illumination.)
  • Conservative bias is discounting the potential impact of new informationand evidence. (Facts and technology change, but the decision maker doesnot).
  • Disregard of “regression toward the mean” is a bias where one expectsexceptional results to continue.
  • Exposure effect is having an unwarranted opinion of a person or thingmerely because you are familiar with them.
  • Eloquence and Manners bias appears when you conclude that someoneknows what they are talking about simply because they are eloquent andwell manned.  This bias also applies to those who are well dressed with a nicehaircut.
  • Groupthink (or Bandwagon) bias occurs when you eschew due diligenceand chose to act because everybody else is.
  • Halo effect is a bias where you allow one positive trait, such as fame orprior success in another discipline, to spill over in areas requiring a moredispassionate assessment. (Look at celebrities in politics and the marketingof consumer goods).
  • Illusion of control is a bias where you think you can control the outcome ofevents when you really have no control whatsoever.  (You increase yourwager when the dice are in your control).
  • Ostrich bias is discounting the importance of obviously negativeinformation. (red cheeks)
  • Professional bias is analyzing events primarily through the lens of yourown profession, and not making a broader, more objective analysis.
  • System justification is a bias leading you to defend and bolster the statusquo.
  • Zero Risk bias is a focus on reducing all risk, including relativelyinsignificant risks, as opposed to reducing manageable risk.

I could provide examples for each of these, but most people, as they read thedefinitions are already recalling examples from their own experience.

Even armed with this knowledge, we are not immune.  It’s known as “Blind spot”bias — a tendency not to acknowledge our own biases.

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