Behavioural economic theory is relatively new concept, but it raises some interesting ideas to think about.
Recognizing
your biases helps focus your mind when it comes to money.
Behavioural
scientists have found we experience far more pain when we lose money than we
do pleasure when we make a profit. This bias was termed ‘loss aversion’ by
Daniel Kahneman and Amos Tversky. Loss aversion has a strong relationship with
risk – it means we prefer to avoid financial risk, even if the potential
returns are better.
Let’s look
at one of the tests Kahneman and Tversky used to examine loss aversion. I want
you to think about what you would do in this situation – but don’t overthink
it. Focus on your initial reaction because that will be your biases acting for
you.
If you were
given a choice between receiving a guaranteed $900, or having a 90% chance of
gaining $1,000 but a 10% chance of losing it all, what option would you take?
What did you
do? Most participants took the $900 that is presented as ‘risk free’. But, when
you do the cold, hard maths, the ‘risk’ is the same. That is: Expected value =
($1,000 × 0.9) + ($0 × 0.1) = $900
Now reverse
the choice. If you had a choice between a guaranteed loss of $900 or a 90%
chance of losing $1,000 but a 10% chance of not losing anything, what option
would you take?
Most of the participants in the study took the risk of losing $1,000 with the small chance of losing nothing as Kahneman and Tversky found. Like the first scenario, the cold hard maths shows that the expected value is a $900 loss.
It’s
important to understand that this is your biases influencing you to do what you
believe is the right thing. That right thing might not be the ‘rational’ thing,
because rational isn’t human.
If we take
the Kahneman and Tversky study into the real world, a 2020 report from the
Australian Securities Exchange (ASX) found more than 36% of Australian adults
have never invested. There’s a variety of reasons behind this, but the
underlying theme is the fear of losing money on the markets. When it comes to
loss aversion you need to think about loss as a relative factor, rather than
the be-all and end-all.
