Loss aversion in financial decisions

Loss aversion – our tendency to value losses twice as high as equivalent gains – was first described by Daniel Kahneman and Amos Tversky. Such a differential treatment of losses and gains interferes with optimal investment strategies. This is something financial advisors struggle with as they try to help their clients.

We are beginning to understand how loss aversion arises from our brain processes. Fear circuits, namely the amygdala, are involved in processing losses. Knowing this, we can look for ways to deal with fear in other circumstances, and see if they can be adapted to advising financial clients. It turns out financial advisors are already using some, but not all of these strategies. Thus, an understanding of the brain allows us to push our thinking and design new strategies.

For details, see the article Thom Alison and I co-wrote. It appears in the January 2014 issue of Financial Advisor.

Are you overconfident?

If you do not think so, try this test. For each of the following questions, choose a high and a low estimate so you are 90% certain that the answer is within the range. This means at the end, only one in ten answers will be outside your range. When you are done, scroll down for the answers.

    Low High

1

Air distance between Paris and London, in miles    

2

Gestation period, in days, of an African Elephant    

3

Average weight of the smallest bird species, in ounces    

4

Number of countries in the European Union    

5

Number of time zones in Russia    

6

Mass of the sun relative to the earth (1 sun = x earths)    

7

Depth, in feet, of the deepest known point in the oceans    

8

Year William Shakespeare was born    

9

Weight, in tons, of the Statue of Liberty    

10

Speed of sound, in feet/second, in dry air at 68 degrees F    

This test was adapted from Decision Traps, Russo & Shoemaker, 1989.

 

How did you do? If you got more than one wrong, you are just like most of us.

Overconfidence can serve us well when it gets us moving.

For a man to achieve all that is demanded of him, he must regard himself as greater than he is. Goethe

Overconfidence can also lead to disaster, as in the Bay of Pigs.

To know that we know what we know, and that we do not know what we do not know, that is true knowledge. Confucius

To make a decision, think like Confucius. Once you have made a decision, think like Goethe.

This post was cross-posted on thinkingerr0rs.com and AndreGolard.com

Answers: 1) 213, 2) 645, 3) 0.065 (the Bee Hummingbird), 4) 28, 5) 9, 6) 330,000, 7) 36,069, 8) 1594, 9) 225, 10) 1,126

Decisive – Heath brothers

Decisive, the new book by the Chip And Dan Heath, is really a book about thinking errors - and how to avoid them for better decision making.

For more details, have a look at my new blog on decision making.

Reset

114,235. This was the number of comments on this blog after ignoring it for a long while. Scanning through, it all looked like spam. Please accept my apologies if you tried to post a legitimate comment. The only practical option was to delete all.

So what errors did I make? Perhaps the most important was that if you ignore something long enough, it no longer pops in your mind very often. And when it does, it is much less vivid than it once was, making it easier to ignore.

So, how long has it been since you have had a medical/dental checkup? How about your car? Are you current on oil changes and tune-ups? Do you have a system to avoid such lapses? What else might you be ignoring that might bite you later?

As for this blog, it is back. Expect something new shortly.

My Stroke of Insight

Jill Bolte Taylor, PhD has a unique perspective on being a stroke victim. She had one in her mid-thirties. She recovered. What made her situation unique was her training in neuroanatomy: it put her in a unique position to analyze what was happening to her brain. She tells her story in her book: My Stroke of Insight: A Brain Scientist’s Personal Journey.

Why talk about such a book on a blog dedicated to thinking errors? For several reasons: the book tells us how much unconscious processing happens in our brains. It tells us we can change, in this case recover. It tells us we can chose which thoughts will linger, and which we can let go.

On the morning of December 10, 1996, things did not feel right. First there was a sharp pain behind her left eye. After getting up she started feeling detached from her body. Her coordination was uneasy, her balance impaired. It is not until her right arm dropped that Jill realized what was happening: she was having a stroke. By then her ability to remember a phone number, dial it and speak had been dramatically reduced. Things came in and out of focus. She managed to call work, where a colleague recognized the garbled sounds as her, in trouble. He organized a rescue.

The hemorrhage on the left side of her brain had wiped out her ability to read, speak, do things in sequence, and recognize the boundaries of her own body. All the sounds and sights that we normally navigate without noticing became painful to absorb. The experience was not totally negative: unencumbered by the left, rational brain, she felt a sense of peace, of being one with the universe, of time being immaterial. Did she really want to fight to go back to being a different person she did not remember? Jill decided she did.

A blood clot was surgically removed, and a slow recovery process began. At first, individual letters were just wiggles. They had no meaning, no associated sound, and piecing them into words had to be re-learned. Everything had to be re-learned: it is OK to cross a line on the cement sidewalk. The line between the sidewalk and a lawn requires more attention. Recovery took eight years. Patient support by family and friends was crucial.

Along the way, associations between words, their meaning and emotional content were re-learned. One advantage of having an essentially blank slate is that Jill had the opportunity to choose which feelings and behaviors she wanted to regain, and which she needed to recognize and set aside when they appeared. What drove her recovery was her awareness of her mind.

Few of us will ever have a blank slate to work with. Nonetheless, when we pay attention to our thoughts and recognize a thought pattern, we can learn to alter our response. When it comes to recognizing thinking errors, metacognition (thinking about our thinking) is often the first step. Next, we need tools to change our response to do better.

This may not seem to be easy but it is worth trying, and it is within reach. To illustrate I will use a quote from John Otterness at UCLA: “Felipe showed up in my Kindergarten class one day and said, “I went home last night and I started thinking. Then I started thinking about thinking. And then I started thinking about thinking about thinking. Then I got tired and went to bed.” Felipe was well on the way to metacognition!”

Predictably Irrational

Predictably Irrational, Revised and Expanded Edition: The Hidden Forces That Shape Our Decisions is a good read. One thing that sets this book apart from others on similar topics is the source of the information. All the data, all the experiments cited here come from the work of the author and his colleagues. This is fresh material. You will not hear for the nth time about an experiment performed in Antonio Damasio’s lab.

The tests are fun. Here is an example. To test how biases shape our taste perception, college students were offered free beer. Finding volunteers must have been easy. The students were asked to try beer A (a standard lager), or beer B. Beer B was A plus two drops of balsamic vinegar per ounce. In a first set of tests, students were told nothing about beers A and B, and were asked which they preferred. Next, other students were offered the same choice, but were told ahead of time that beer B had vinegar added. The third set of experiments was done telling students about the vinegar after they tasted the two beers. How did students like A and B? If they were told nothing, a majority chose B. If they were told about the vinegar ahead of time, they chose A. If they were told after tasting, they chose B. What this tells us is that an expectation of a sour, unpleasant concoction affected what students tasted!

This confirms what we have known for a long time: we see what we want to see, and hear what we want to hear. Our senses do not give us an accurate representation of reality. Our expectations shape our experience.

This is one of the many topics tackled in the book, all through the eyes of an experimenter. Arielly gets us to question our actions, our beliefs, and he does this in an entertaining fashion. Why are free offers so attractive? Why do we overvalue what we have? Some of the questions have deep economic implications: prices can have little to do with supply and demand. Some push us to have a deeper look at ourselves: could we really act so differently when aroused than when calm?

This book is challenging and fun at the same time. Read it.

Staying the course

We have all been in a situation – a project, a relationship – where we feel we have invested so much we need to keep going. In a related set of errors, once we form a habit we find it hard to change course. Sometimes we get so used to doing something we no longer question how things got started, or why we are acting the way we are. Who would have thought so many people would get accustomed to paying $4 for a cup of coffee?

In the late 90s, Cellpro, a Bothell WA biotech startup got into a patent fight against Baxter Healthcare and Johns Hopkins University. How things started is a different error: our propensity to think others will view things the way we do. Cellpro was convinced a judge would. Initially the company had the opportunity to license the technology from Baxter. Two other biotech companies did. Cellpro refused, and the litigation process started. Such a fight against much larger competitors consumes not only cash, but also the attention of senior management. The company fought to the end – its end. Cellpro went out of business.

Examples of such errors abound:

  • This company makes X. For Intel it was memory chips. They were getting beat by cheaper Japanese chips. Yet, memory chips were what Intel did. It took strong leaders to move away from memory chips, and focus on the emerging market for microprocessors. The rest is history.
  • You start feeling like your significant other is a “fixer upper”. Yet, you have invested so much of yourself you make yourself believe things will get better.
  • Vietnam

In the case of relationships, the cause for our inability to let go may be the collocation of two types of receptors in our reward centers: dopamine (known for mediating pleasure responses), and oxytocin (a molecule involved in bonding). Bonding can be crucial for survival. After hatching, goslings will follow the first moving thing they see, and keep following it. Typically it will be their mother. A human experimenter once found a lifelong follower. Sometimes we act like goslings: once set in one direction, we have a hard time deviating.

How can we do better? Become a Buddhist monk. Learn to let go. Seriously, there are some things you can do to figure out if you are getting pulled in a no-win battle. Just ask yourself: if I were being brought in now, would I take that project? If the answer is no, run!

Periodically we need to look at our habits. Maybe something made sense in the past, but no longer does. What is the cost of “staying the course”? What else could we do?

Remember the goslings. Do you want to act like one?

The overflowing brain

The Overflowing Brain: Information Overload and the Limits of Working Memory

Sexy title, important topic given we are bombarded with ever more information.

Here is how it works: our working memory (the number of things we can juggle in our head at any one time) is very limited. The amount of working memory we have can be estimated. It is only about seven plus or minus two items.

Working memory determines our ability to solve complex problems. The same brain areas are also used to focus our attention. This makes it hard to focus on two different things at once, or to perform two complicated tasks at once. This is why multi-tasking does not work.

Working memory can be somewhat improved through training. The benefits can be in the form of improved problem solving, or ability to focus. This may help people with ADHD. Drugs that improve performance in ADHD patients also boost performance in normal subjects. This is not too surprising: ADHD is not an all or none disease: just like IQ, we all have different degrees of attention. The potential for abuse of these drugs is worrisome.

An interesting chapter deals with the Flynn effect: IQ scores have been increasing. The increase is about 20 points from 1900 to 1990, and the effect may be increasing. The author proposes that this is due to the increased complexity of our society, and the larger amounts of information we have to process.

Here you have it, in half a page. Read the book if you want to hear who came up with what hypothesis, which ones currently seem to be right, and how this was done.

Loss Aversion

If we are offered a coin toss in which we may lose $10, we will on average ask for a potential win of $20. Why is it that we are more sensitive to losses than to equivalent gains? How can we avoid making hasty, irrational decisions when we deal with an immediate loss, or the possibility of a loss?

This phenomenon takes many forms:

  • The stock market is going up. You only have twenty percent of your money in stocks. You feel you are losing out, and buy more stocks. Pretty soon, you may have shifted most of your investments to the stock market. This is when the bubble bursts. This has happened many times, to many people, over the course of numerous bubbles.

  • You lose a poker hand. You want to recoup your loss. To do so you bet on riskier hands. You lose more.

  • A flat tire made you late. You want to make up lost time. You are speeding, and you go through a red light.

  • You rent a car. Your car insurance and credit card company will take care of the costs in case of an accident. Yet you let the sales rep convince you to get the loss damage waiver.

Nobody seems to be immune to loss aversion. Since 1926, stocks have outperformed bonds by a factor of 10. Yet economics Nobel Prize winner Harry Markowitz split his own investment portfolio equally between stocks and bonds. Only neurological patients who are unable to feel any emotions seem to be immune to loss aversion.

The neurological basis for our greater sensitivity to losses than to equivalent gain is still unclear. A broad set of brain areas is activated in response to gains. Interestingly, losses do not appear to activate different areas: the activity of the same areas decreases.

How can we do better?

When faced with an immediate loss, the best way to avoid the trap of loss aversion is to take the long view. Is this loss significant over the long run? Are there risks involved with reacting the way I am tempted to? More often than not the answers are no, and yes. Are these risks worth taking?

Sway

Sway: The Irresistible Pull of Irrational BehaviorThrough many stories, Ori and Rom Brafman tell us how we fool ourselves. Some of the topics well known: loss aversion, value attribution, our reluctance to speak up in a group. They are told with fresh, entertaining stories. Other topics are less often covered in the context of thinking errors.

What are the cultural differences in terms of deciding what is fair? One interesting approach is to look at the behavior of the studio audience in local versions of Who Wants to Be a Millionaire. A contestant has to choose between four possible answers to a question. If he is not sure which answer to pick, once in the contest he has the option to ask the audience to vote for the right answer. In the US, the audience will try to help. In elitist France, the audience may turn against a contestant. If he looks stupid, the audience will think he does not deserve to win. They will give a wrong answer. In Russia, the audience is useless to the contestant. After generations growing up in an egalitarian regime, the thought of someone getting rich quickly just seems wrong. Why should this guy become wealthy? The audience tends to give wrong answers.

Another interesting topic is why rewards can backfire. Ask a friend to help you move, and he reluctantly does. Ask the same friend the same favor and offer $10, and he will remind you that there are professional movers out there. Why should your friend turn down $10? fMRI studies show two parts of the brain being activated in this scenario. In the absence of a reward the posterior superior temporal sulcus is activated. This is an area involved in social interactions. The authors call it our “altruism center”. If a reward is offered, our “pleasure center”, the nucleus accumbens lights up. The problem is, if the nucleus accumbens is activated, the posterior superior temporal sulcus is not. Our altruistic tendencies are lost. We react to the reward. If it seems insufficient we reject it.

This book is a good read.