The psychology of human misjudgment ii

The Psychology of

Human Misjudgment- II

Bias # 2

Perceptual contrast

Cialdini’s Sharon

“Dear Mother and Dad, Since I left for college I have been remiss in writing and I am sorry for my thoughtlessness in not having written before.“I will bring you up to date now, but before you read on, please sit down. You are not to read any further unless you are sitting down, okay?

“Well, then, I am getting along pretty well now. The skull fracture and the concussion I got when I jumped out the window of my dormitory when it caught on fire shortly after my arrival here is pretty well healed now...

“I only spent two weeks in the hospital and now I can see almost normally and only get those sick headaches once a day...

“Fortunately, the fire in the dormitory, and my jump, was witnessed by an attendant at the gas station near the dorm, and he was the one who called the Fire Department and the ambulance...

He also visited me in the hospital and since I had nowhere to live because of the burnt-out dormitory, he was kind enough to invite me to share his apartment with him. It's really a basement room, but it's kind of cute. He is a very fine boy, and we have fallen deeply in love and are planning to get married. We haven't set the exact date yet, but it will be before...

...my pregnancy begins to show. Yes, Mother and Dad, I am pregnant. I know how much you are looking forward to being grandparents and I know you will welcome the baby and give it the same love and devotion and tender care you gave me when I was a child...

“The reason for the delay in our marriage is that my boyfriend has a minor infection which prevents us from passing our premarital blood tests and I carelessly caught it from him...

“I know that you will welcome him into our family with open arms. He is kind and, although not well educated, he is ambitious...

“Now that I have brought you up to date, I want to tell you that there was no dormitory fire, I did not have a concussion or skull fracture, I was not in the hospital, I am not pregnant, I am not engaged, I am not infected, and there is no boyfriend. “However, I am getting a “D” in American History and an “F” in Chemistry, and I want you to see those marks in their proper perspective. Your loving daughter, Sharon.”

What will happen if you put this in your mouth and then...

and then you put this in your mouth?

Dan Airely

Dan Airely

Decoy

Decoys in comparables

Example of 2nd most expensive wine on the menu - the most expensive is the decoy which is supposed to make the 2nd most expensive (and very profitable for the restaurant) wine look better than the cheaper ones and good value compared to the most expensive one.

Buying a Lamp

Buying a Car

In availability bias - this was about anchoring - You were anchoring to price of lamp and price of car and NOT anchoring to wealth

Here its about contrast - high contrast - the Rs 1000 saving on a lamp looks BIG but SMALL in a car

$15$15$15$15 $15 $95 $95 $150

Experiments show that average wine sales increase substantially by having the $150 bottle listed right next to the $95 bottle. Moreover, the sales increase happens not because of a rise in sales of the $150 bottle but due to a rise in sales of the $95 bottle. The role of the $150 bottle is to act as a decoy to make the $95 bottle appear more desirable.

The way to sell a lot of $800 shoes is to display some $1,200 shoes next to them...

Averaging down is a good idea but like most good ideas, if they are carried to the extreme, become bad ideas…

Blind averaging down can be injurious to your (financial) health.

Just because a stock has fallen 80%, doesn’t necessarily make it cheap and worthy of averaging down

Catching a

Falling Knife

Blind averaging down can cause grave harm if you do it with the wrong kind of stock.

Beware of Little Expenses for A Small Leak will Sink

a great ship

Here is another example…

Small things add up

When compared with a LARGE investment, They LOOK small, but they add up and become BIG.

How would the Buy-and Hold Strategy do?

How would the Buy-and Hold Strategy do?

tax-paying investorswill realize a far, far

greater sum from a single investment that

compounds internally at a given rate than from a

succession ofinvestments compounding at

the same rate.

Is a Rs 10 stock cheaper than a Rs 100 one?

Stock splits can’t make people richer?

How could exchanging a Rs 100 note for ten Rs 10 notes make you rich?

If you put a frog in boiling hot water, it will instantly jump out and escape

But if you put a frog in lukewarm water and slowly boil it, it will slowly boil to death!

While there is no truth to this story whatsoever, the human equivalent of the boiling frog is there in all of us...

“Cognition, misled by tiny changes involving

low contrast, will often miss a trend that

is destiny.”

“Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny.”

Killing Me Softly...

Digital camera’s killed the photographic film business.

But it did not happen in a day, or a month, or a quarter.

It was slow, painful (for films)….



“Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny.”

You’ve just got to acquire the skill to spot long-term trends - even if they are slow - indeed PARTICULARLY because they are slow because OTHERS who are victims of low contrast are going to MISS IT

Sometimes the light at the end of the tunnel is from an oncoming train!

Jerome S. Bruner and Mary C. Potter, “Interference in Visual Recognition,” Science, Vol.

144 (1964), pp. 424-25.

Pictures of common objects, coming slowly into focus, were viewed by adult observers. Recognition was delayed when subjects first viewed the pictures out of focus. The greater or more prolonged the initial blur, the slower the eventual recognition. Interference may be accounted for partly by the difficulty of rejecting incorrect hypotheses based on substandard cues.

You need to distance yourself from the noise...

Figures in Rs. Million


Market Cap: 13,500 cr.






Down 83% in 6 years

Look what SAIL looked like in 2002-03.

Stock was quoting at Rs 6.

In 4 years it went to 150. How did this happen?

It did not happen in a day, or a week, or a month.

It would have been missed by those who focus on short term “noise”

The shorter the time frame, the more the randomness.

Noise Vs. Signal

"The more frequently you look at data, the more noise you are disproportionally likely to get (rather than the valuable part called the signal); hence the higher the noise to signal ratio. And there is a confusion, that is not psychological at all, but inherent in the data itself. Say you look at information on a yearly basis, for stock prices or the fertilizer sales of your father-in-law’s factory, or inflation numbers in Vladivostock. Assume further that for what you are observing, at the yearly frequency the ratio of signal to noise is about one to one (say half noise, half signal) —it means that about half of changes are real improvements or degradations, the other half comes from randomness. This ratio is what you get from yearly observations. But if you look at the very same data on a daily basis, the composition would change to 95% noise, 5% signal. And if you observe data on an hourly basis, as people immersed in the news and markets price variations do, the split becomes 99.5% noise to .5% signal. That is two hundred times more noise than signal —which is why anyone who listens to news (except when very, very significant events take place) is one step below sucker." - Taleb

This is a fantastic description of markets from Ben Graham’s Security Analysis.

Noise vs. Signal

It tells you what you need to IGNORE and what you need to FOCUS on

There are only a FEW things out there that are important. All the rest is NOISE.

Bias # 3

Deprival Super

Reaction

Text

Rules:

1. Highest bidder wins

2. 2nd highest bidder also has to pay his bid price to the auctioneer.

Deprival Super Reaction Syndrome

(DSRS)

If you deprive me, I’ll have a

super reaction!

The human equivalent of the dog deprived of his bone is there in all of us

Choose between:

85% chance of winning $100 (the gamble)

or

sure gain of $85 (the sure thing)

Choose between:

85% chance of losing $100 (the gamble)

or

sure loss of $85 (the sure thing)

People tend to accept more risk to avoid losses than to obtain equivalent gains

The reason you like the idea of gaining $85 and dislike the idea of losing $85 is not that these amounts change

your wealth. You just like winning and dislike losing—and you almost certainly dislike losing more than you like winning.

people become

risk seeking

when all their

options are bad.

The Psychology of the Near Miss

DSRS also takes place when you almost have something you love and you “lose it” [“near-misses”]

Two friends sharing a cab to the airport. both miss their flights - one by just 5 min and one by 30 min - who will face more regret

“You own a small casino in Las Vegas. It has fifty standard slot machines which are identical in appearance. “Moreover, they have exactly the same payout ratios. The probability of hitting a jackpot is identical in all of them and they amount of money won in case of a jackpot is also the same. “But there’s one slot machine in this group that, no matter where you put it among the fifty, produces 25% more winnings for the casino at the end of the every day. “What is different about that heavy winning slot machine?

What SHOULD you do when the light turns yellow?What do yo ACTUALLY do?What happens to people’s risk assessment abilities when are about to “lose something?”They become gamblers…

Combines with Overconfidence

In a game of skill, like shooting, a near miss gives useful feedback and encourages the player by indicating that success may be within reach

What will happen if slot machines and instant lotteries are contrived to ensure a higher frequency of near misses than would be expected by chance alone?

Near misses in random situations fool people into “trying harder” next time

361204 965304 865305

winning lottery number is 865304

The owner of which ticket is likely to “try harder” next time?

You’ve got to learn how to deal with losses in life (personal and professional). One way to do that is to invert. Try to re-frame the problem from a loss frame to a gain frame to de-bias yourself.

Countdown effect

Volumes rise during the last few minutes of trading. Why?

“I am going to lose this opportunity to buy (sell) this stock because it would open higher (lower) tomorrow morning. Therefore I am going to behave like the man who when approaching a traffic crossing sees the light turn yellow from green…”

The fellow who was contemplating selling is worried the stock will open even lower yesterday and does not want to wait until tomorrow. He reduces his price and sells the stock.

From Cialdini’s Influence:

“There is something almost physical about the desire to have a contested item. Shoppers at big close-out or bargain sales report being caught up emotionally in the event. Charged by the crush of competitors, they swarm and struggle to claim merchandise they would otherwise disdain.”

“Such behavior brings to mind the “feeding frenzy” of wild, indiscriminate eating among animal groups. Commercial fishermen exploit this phenomenon by throwing a quantity of loose bait to large schools of certain fish. Soon the water is a roiling expanse of thrashing fins and snapping mouths competing for the food. At this point, the fishermen save time and money by dropping unbaited lines into the water, since the crazed fish will bite ferociously at anything now, including bare metal hooks.”

“There is a noticeable parallel between the ways that commercial fishermen and department stores generate a competitive fury in those they wish to hook. To attract and arouse the catch, fishermen scatter some loose bait called chum. For similar reasons, department stores holding a bargain sale toss out a few especially good deals on prominently advertised items called loss leaders. If the bait, of either form, has done its job, a large and eager crowd forms to snap it up. Soon, in the rush to score, the group becomes agitated, nearly blinded, by the adversarial nature of the situation. Humans and fish alike lose perspective on what they want and begin striking at whatever is being contested.”

From Cialdini’s Influence:

“Lest we believe that the competition-for-limited-resources-fever occurs only in such unsophisticated forms of life as tuna and bargain-basement shoppers, we should examine the story behind a remarkable purchase decision made in 1973 by Barry Diller, who was then vice president for prime-time programming at the American Broadcasting Company, but who has since been labeled the “miracle mogul” by Time magazine in reference to his remarkable successes as head of Paramount Pictures and the Fox Television Network. He agreed to pay $3.3 million for a single television showing of the movie The Poseidon Adventure. The figure is noteworthy in that it greatly exceeded the highest price ever previously paid for a one-time movie showing: $2 million for Patton. In fact, the payment was so excessive that ABC figured to lose $1 million on the Poseidon showing. As NBC vice president for special programs Bill Storke declared at the time, “There’s no way they can get their money back, no way at all.

How could an astute and experienced businessman like Diller go for a deal that would produce an expected loss of a million dollars? The answer may lie in a second noteworthy aspect of the sale: It was the first time that a motion picture had been offered to the networks in an open-bid auction. Never before had the three major commercial networks been forced to battle for a scarce resource in quite this way. The novel idea of a competitive auction was the brainchild of the movie’s flamboyant showman-producer, Irwin Allen, and a 20th Century Fox vice president, William Self, who must have been ecstatic about the outcome. But how can we be sure that it was the auction format that generated the spectacular sales price rather than the blockbuster quality of the movie itself?

Some comments from the auction participants provide impressive evidence. First came a statement from the victor, Barry Diller, intended to set future policy for his network. In language sounding as if it could have escaped only from between clenched teeth, he said, “ABC has decided regarding its policy for the future that it would never again enter into an auction situation.” Even more instructive are the remarks of Diller’s rival, Robert Wood, then president of CBS Television, who nearly lost his head and outbid his competitors at ABC and NBC: We were very rational at the start. We priced the movie out, in terms of what it could bring in for us, then allowed a certain value on top of that for exploitation. But then the bidding started. ABC opened with two million. I came back with two point four. ABC went to two point eight. And the fever of the thing caught us. Like a guy who had lost his mind, I kept bidding. Finally, I went to three point two; and there came a moment when I said to myself, “Good grief, if I get it, what the heck am I going to do with it?” When ABC finally topped me, my main feeling was relief. It’s been very educational.”

According to interviewer Bob MacKenzie, when Wood made his “It’s been very educational” statement, he was smiling. We can be sure that when ABC’s Diller made his “never again” announcement, he was not. Both men had clearly learned something from the “Great Poseidon Auction.” But for one, there had been a $1 million tuition charge. Fortunately, there is a valuable but drastically less expensive lesson here for us, too. It is instructive to note that the smiling man was the one who had lost the highly sought-after prize. As a general rule, whenever the dust settles and we find losers looking and speaking like winners (and vice versa), we should be especially wary of the conditions that kicked up the dust—in the present case, open competition for a scarce resource. As the TV executives now know, extreme caution is advised whenever we encounter the devilish construction of scarcity plus rivalry.

When we watch something we want become less available, a physical agitation sets in. Especially in those cases involving direct competition, the blood comes up, the focus narrows, and emotions rise. As this visceral current advances, the cognitive, rational side retreats. In the rush of arousal, it is difficult to be calm and studied in our approach. As CBS Television’s president, Robert Wood, commented in the wake of his Poseidon adventure, “You get caught up in the mania of the thing, the acceleration of it. Logic goes right out the window.”

“In many of these acquisitions,

managerial intellect wilted in competition

with managerial adrenaline The thrill of the chase blinded the pursuers to the

consequences of the catch.”- Warren

Buffett

Fear of losing something possessed, or something not possessed but almost possessed.

Its processed in amygdala - part of the innermost brain.

Basic Instinct - part of our genome

“Run away when you sense danger” had a huge survival advantage when your ancestors lived in the caves. But modern world is different….

Basic Instinct

Neuroeconomics shows that financial losses and mortal danger are processed in the same part of the brain: Amygdala

Game: 3 types of subjects were chosen to play a game: normal brains, damaged amygdalas, brains damaged in areas other than amygdala (controls). Each player was given a starting capital of $20 and was then offered a choice to play a game or not. The game involved a coin toss. To play the game one had to invest $1

Heads, you lose $1Tails, you win $2.5

Total number of rounds: 20

What would you do?

You’d play all the rounds. Odds is heavily loaded - you may lose a few rounds but overall result in 20 rounds is expected to in your favor.

Damaged amygdalas played 84% of the rounds

Normals played 63%

Controls played 61%

Why???

Damaged amygdalas did much better than the other two

groups!

This does not mean that to be rational you have to experience brain damage :-)

Fear of losing our MTM profits makes us sell out of

good decisions too early.

The stupidity of “you can’t go broke taking a profit.”

Reptilian or lizard brain

“lizard brain” describes the older, more

emotional parts of the human brain. The lizard

brain is the most important driver of

market irrationality, and it is completely

ignored by traditional finance and economics.

We are built to solve the problems faced by our ancestors. Because modern industrialized society differs systematically from the world of our ancestors, we tend to get into trouble.

Our brains, like our bodies, reflect the world of our ancestors. In particular, our lizard brains are pattern-seeking, backward-looking systems that allowed us to forage successfully for food and repeat successful behaviors.This system helped our ancestors survive and reproduce, but financial markets punish such backward-looking decisions.

framing

How would you frame requests DSRS

Regular bulbs vs. CFL

Today Jack and Jill each have a wealth of 5 million.

Yesterday, Jack had 1 million and Jill had 9 million.

Are they equally happy? (Do they have the same utility?)

“Bernoulli’s Utility theory assumes that the utility of their wealth is what makes people more or less happy. Jack and Jill have the same wealth, and the theory therefore asserts that they should be equally happy, but you do not need a degree in psychology to know that today Jack is elated and Jill despondent. Indeed, we know that Jack would be a great deal happier than Jill even if he had only 2 million today while she has 5. So Bernoulli’s theory must be wrong.” - Kahneman

People don’t anchor to wealth. They anchor to CHANGES in wealth.

In addition to whatever you own, you have been given $1,000.

You are now asked to choose one of these options:

50% chance to win $1,000

OR

get $500 for sure

In addition to whatever you own, you have been given $2,000.

You are now asked to choose one of these options:

50% chance to lose $1,000

OR

lose $500 for sure

You can easily confirm that in terms of final states of wealth—all that matters for Bernoulli’s theory—problems 3 and 4 are identical. In both cases you have a choice between the same two options: you can have the certainty of being richer than you currently are by $1,500, or accept a gamble in which you have equal chances to be richer by $1,000 or by $2,000. In Bernoulli’s theory, therefore, the two problems should elicit similar preferences.

When directly compared or

weighted against each other, losses loom larger than gains.

“This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.” - Kahneman

“The quantity of a man’s pleasure from a ten-dollar gain does not exactly match the quantity of his displeasure from a ten-dollar loss.”

We concluded from many such observations that “losses loom larger than gains” and that people are loss averse. You can measure the extent of your aversion to losses by asking yourself a question: What is the smallest gain that I need to balance an equal chance to lose $100? For many people the answer is about $200, twice as much as the loss. The “loss aversion ratio” has been estimated in several experiments and is usually in the range of 1.5 to 2.5.

Professional risk takers in the financial markets are more tolerant of losses, probably because they do not respond emotionally to every fluctuation. When participants in an experiment were instructed to “think like a trader,” they became less loss averse and their emotional reaction to losses (measured by a physiological index of emotional arousal) was sharply reduced.

What are the consequences?

“Being overly sensitive to loss

leads people to opt for a certain gain

over one that offers a high

possibility of a larger gain.”-

Daniel Kahneman

Stocks Vs. Bonds

In real life that usually translates into a preference for fixed-income investments over stocks. A guaranteed 6 percent or 7 percent annual return from Uncle Sam may seem a lot more appealing than the “chance” to earn 11 percent or more a year in stocks. But as we’ll see later on, the dangers of the stock market may not be as important as the ravages of inflation. So to the extent that you opt for “safe” investments—such as bonds, annuities, and other fixed-income or life insurance products—over more volatile but higher-paying ones, your loss aversion may be costing you a lot of money.”

Those 400 basis points make hell of a lot of difference.

making concessions

hurts

In labor negotiations, it is well understood by both sides that the anchor is the existing contract and that the negotiations will focus on mutual demands for concessions relative to that anchor. The role of loss aversion in bargaining is also well understood: making concessions hurts.

Loss aversion creates an asymmetry that makes agreements difficult to reach. Status Quo Bias

“The concessions you make to me are my gains, but they are your losses; they cause you much more pain than they give me pleasure. Inevitably, you will place a higher value on them than I do. The same is true, of course, of the very painful concessions you demand from me, which you do not appear to value sufficiently!”

“Negotiations over a shrinking pie are especially difficult, because they require an allocation of losses. People tend to be much more easygoing when they bargain over an expanding pie.”

In the world of territorial animals, this principle explains the success of defenders. When a territory holder is challenged by a rival, the owner almost always wins the contest.

Turf battles take place in boardroom too

Loss aversion explains much of what happens when institutions attempt to reform themselves.

Those who stand to lose will fight harder than those who stand to gain.

Loss aversion also explains the difficulty in carrying out “reorganizations” and “restructuring” of companies, or rationalizing a bureaucracy. As initially conceived, plans for reform almost always produce many winners and some losers while achieving an overall improvement. If the affected parties have any political influence, however, potential losers will be more active and determined than potential winners; the outcome will be biased in their favor and inevitably more expensive and less effective than initially planned. Reforms commonly include grandfather clauses that protect current stake-holders—for example, when the existing workforce is reduced by attrition rather than by dismissals, or when cuts in salaries and benefits apply only to future workers.

Loss aversion favors minimal changes from the status quo in the lives of both institutions and individuals.

Maurice Allais

Allais’s Paradox

In problems A and B, which would you choose?

A. 61% chance to win $520,000 OR 63% chance to win $500,000

B. 98% chance to win $520,000 OR 100% chance to win $500,000

If you are like most other people, you preferred the left-hand option in problem A and you preferred the right-hand option in problem B. If these were your preferences, you have just committed a logical sin and violated the rules of rational choice.

Problem A0.61 × 520000 = 317,2000.63 × 500000 = 315,000First choice is better by 2,200

Problem B0.98 × 520000 = 509,6001.00 x 500,000 = 500,000First choice is better by 9,600

This pattern of choices does not make logical sense, but a psychological explanation is readily available: the certainty effect is at work. The 2% difference between a 100% and a 98% chance to win in problem B is vastly more impressive than the same difference between 63% and 61% in problem A

Decision Weights

Gambles with modest monetary stakes

estimates for gains

You can see that the decision weights are identical to the corresponding probabilities at the extremes: both equal to 0 when the outcome is impossible, and both equal to 100 when the outcome is a sure thing. However, decision weights depart sharply from probabilities near these points. At the low end, we find the possibility effect: unlikely events are considerably overweighted. For example, the decision weight that corresponds to a 2% chance is 8.1. If people conformed to the axioms of rational choice, the decision weight would be 2—so the rare event is overweighted by a factor of 4. The certainty effect at the other end of the probability scale is even more striking. A 2% risk of not winning the prize reduces the utility of the gamble by 13%, from 100 to 87.1.

You should trade against people who price risk emotionally.

Possibility Certainty

Situation 1: you have a 1% chance to win $1 million. You will know the outcome tomorrow.

Situation 2: imagine that you are almost certain to win $1 million, but there is a 1% chance that

you will not.

The anxiety of the second situation will exceed the hope of the first.

The certainty effect is also more striking than the possibility effect if the outcome is a surgical disaster rather than a financial gain. Compare the intensity with which you focus on the faint sliver of hope in an operation that is almost certain to be fatal, compared to the fear of a 1% risk. The combination of the certainty effect and possibility effects at the two ends of the probability scale is inevitably accompanied by inadequate sensitivity to intermediate probabilities.You can see that the range of probabilities between 5% and 95% is associated with a much smaller range of decision weights (from 13.2 to 79.3), about two-thirds as much as rationally expected.

Probabilities that are extremely low or high (below 1% or above 99%) are a special case. It is difficult to assign a unique decision weight to very rare events, because they are sometimes ignored altogether, effectively assigned a decision weight of zero - Utter Neglect. Recall Availability Bias

On the other hand, when you do not ignore the very rare events, you will certainly overweight them. Most of us spend very little time worrying about nuclear meltdowns or fantasizing about large inheritances from unknown relatives. However, when an unlikely event becomes the focus of attention, we will assign it much more weight than its probability deserves. - Excessive Overreaction in Availability Bias.

Rare events get mispriced. Buffett specializes in pricing rare events by selling overpriced insurance to worried buyers of insurance.

These people are protesting against the commissioning of a Nuclear Power Plant in Coastal India

http://en.wikipedia.org/wiki/Kudankulam_Atomic_Power_Project

When you pay attention to a threat, you worry—and the decision weights reflect how much you worry. Because of the possibility effect, the worry is not proportional to the probability of the threat. Reducing or mitigating the risk is not adequate; to eliminate the worry the probability must be brought down to zero.

http://en.wikipedia.org/wiki/Kudankulam_Atomic_Power_Project

The Fourfold Pattern

The top row in each cell shows an illustrative prospect. The second row characterizes the focal emotion that the prospect evokes. The third row indicates how most people behave when offered a choice between a gamble and a sure gain (or loss) that corresponds to its expected value (for example, between “95% chance to win $10,000” and “$9,500 with certainty”). Choices are said to be risk averse if the sure thing is preferred, risk seeking if the gamble is preferred. The fourth row describes the expected attitudes of a defendant and a plaintiff as they discuss a settlement of a civil suit.

when they have to choose between 95% chance to win $10,000” OR “$9,000 with certainty, they

will choose $9,000. They will accept unfavorable settlement.

The top left is the one that Bernoulli discussed: people are averse to risk when they consider prospects with a substantial chance to achieve a large gain. They are willing to accept less than the expected value of a gamble to lock in a sure gain.

You are the plaintiff in a civil suit in which you have made a claim for a large sum in damages. The trial is going very well and your lawyer cites expert opinion that you have a 95% chance to win outright, but adds the caution, “You never really know the outcome until the jury comes in.” Your lawyer urges you to accept a settlement in which you might get only 90% of your claim. You are in the top left cell of the fourfold pattern, and the question on your mind is, “Am I willing to take even a small chance of getting nothing at all? Even 90% of the claim is a great deal of money, and I can walk away with it now.”

The possibility effect in the bottom left cell explains why lotteries are popular. When the top prize is very large, ticket buyers appear indifferent to the fact that their chance of winning is minuscule. A lottery ticket is the ultimate example of the possibility effect. Without a ticket you cannot win, with a ticket you have a chance, and whether the chance is tiny or merely small matters little. Of course, what people acquire with a ticket is more than a chance to win; it is the right to dream pleasantly of winning.

The bottom right cell is where insurance is bought. People are willing to pay much more for insurance than expected value—which is how insurance companies cover their costs and make their profits. Here again, people buy more than protection against an unlikely disaster; they eliminate a worry and purchase peace of mind.

This is Buffett’s speciality. He sells overpriced insurance to people in this cell.

Many unfortunate human situations unfold in the top right cell. This is where people who face very bad options take desperate gambles, accepting a high probability of making things worse in exchange for a small hope of avoiding a large loss. Risk taking of this kind often turns manageable failures into disasters. The thought of accepting the large sure loss is too painful, and the hope of complete relief too enticing, to make the sensible decision that it is time to cut one’s losses. This is where businesses that are losing ground to a superior technology waste their remaining assets in futile attempts to catch up. Because defeat is so difficult to accept, the losing side in wars often fights long past the point at which the victory of the other side is certain, and only a matter of time.

This is the cell in which people who “throw good money after bad” live. It’s where people in denial live. It’s where people who believe in “I have to do whatever it takes to get back in the game” live. It’s where people who think “I have too much invested in this, and I can’t afford to write it off now” live.

desperate fears after losing a lot of money induces

people to take enormous risks with the rest of

their money - Gambler’s ruin

Many gamblers stake everything thats left of their bankroll on the riskiest of the bets - which obviously offer the highest payouts - just to “get back in the game”

Why can’t people afford to write off their losses?

"The combination of loss aversion and narrow framing is a costly curse. Individual investors can avoid that curse, achieving the emotional benefits of broad framing while also saving time and agony, by reducing the frequency with which they check how well their investments are doing. Closely following daily fluctuations is a losing proposition, because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough, and may be more than enough for individual investors. In addition to improving the emotional quality of life, the deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes. The typical short-term reaction to bad news is increased loss aversion. Investors who get aggregated feedback receive such news much less often and are likely to be less risk averse and to end up richer. You are also less prone to useless churning of your portfolio if you don't know how every stock in it is doing every day (or every week or even every month). A commitment not to change ones position for several periods (the equivalent of locking in an investment) improves financial performance."

Recall the ides of signal vs. Noise of Taleb and Graham. Kahneman agrees with both.

But what is broad or narrow framing?

First, a Buffett story.

One day in the early eighties, Warren Buffett joined a few friends for a game of golf. The men did a lot of betting and at one session, Jack Bryne, Chairman of GEICO, proposed a novel side bet. For a "premium" of $11, Bryne would agree to pay $10,000 to anyone who hit a hole-in-one over the weekend. Everyone reached for the cash - everyone, except for Buffett, who coolly calculated that, given the odds, $11 was too high a premium. His pals could not believe that he - by then, almost a billionaire- would be so tight and began to make fun of him for it. Buffett, grinning, noted that he measured an $11 wager exactly as he would $11 million. He kept his wallet tightly zipped.

You are offered a gamble on the toss of a coin.

If the coin shows tails, you lose $100.

If the coin shows heads, you win $150.

Is this gamble attractive?

Would you accept it?

To make this choice, you must balance the psychological benefit of getting $150 against the psychological cost of losing $100. How do you feel about it? For most people, the fear of losing $100 is more intense than the hope of gaining $150.

Although the expected value of the gamble is obviously positive, because you stand to gain more than you can lose, you probably dislike it—most people do. They reject this bet.

But what if you were offered this bet a 100 times? Then what will you do?

Hmmm...

What if you are offered it only once? Let me give you some advice on broad framing vs narrow framing.

Are YOu On Your

Deathbed?

“I sympathize with your aversion to losing any gamble, but it is costing you a lot of money. Please consider this question: Are you on your deathbed? Is this the last offer of a small favorable gamble that you will ever consider? Of course, you are unlikely to be offered exactly this gamble again, but you will have many opportunities to consider attractive gambles with stakes that are very small relative to your wealth. You will do yourself a large financial favor if you are able to see each of these gambles as part of a bundle of small gambles and rehearse the mantra that will get you significantly closer to economic rationality: you win a few, you lose a few. The main purpose of the mantra is to control your emotional response when you do lose. If you can trust it to be effective, you should remind yourself of it when deciding whether or not to accept a small risk with positive expected value.” - Kahneman

“If you have the emotional discipline that this rule requires, you will never consider a small gamble in isolation or be loss averse for a small gamble until you are actually on your deathbed—and not even then.” - Kahneman.

What did he mean by those last three words?

Think about it...

Thank You

Documents

The psychology of human misjudgment ii