Understanding Your Relationship to Risk: Rolling the Dice and Loss Aversion

Stephen Horan writes:

Everywhere we turn, psychological tests are available to help us better understand ourselves and our own behavior. But often these tests fail to shed light on a person’s relationship to risk, particularly the risk of losing money.

That’s why I like to do my own thought experiment. When I speak to groups, I often ask the participants to consider the following scenario:

Suppose you are sitting in a captivating presentation and someone comes in and locks the door. Then the person announces that everyone in the room is free to leave under two circumstances. You can leave if you pay a $1,000 fee (à la Hotel California) or you can leave after flipping a coin and going double or nothing. If the coin turns up heads, you exit for free; if it’s tails, you pay $2,000.

On a consistent basis, some 80 to 85% of the people in the room choose to flip the coin. The results are always very biased toward flipping, and that says something about the human tendency toward loss aversion.

The classical theory of the rational, economic man would have him avoid risk and thereby avoid the coin flip. The difference in this case, however, is the negative expected returns (a loss of $1,000 in each case since with option B you have a 50% chance of paying $2,000).

Since negative returns are at play, a loss aversion mechanism kicks in, and people will actually go double or nothing in order to keep from losing—thereby taking more risk.

The first reaction I get is surprise from people who otherwise think they make “rational” decisions regarding money. They realize for the first time the innate nature of loss aversion. That’s why I put the term “rational” in quotes. People are not necessarily “irrational” or stupid on this point; they are simply being human.

That thinking is foundational to becoming a successful trend following trader.

Note: Shout to Alistair Evans for the hat tip.