Problem 1: Which do you choose?
Get Rs.900 for sure OR 90% chance to get Rs.1,000
Problem 2: Which do you choose?
Lose Rs.900 for sure OR 90% chance to lose Rs.1,000
What we will choose in problem 1 and problem 2?
When this is asked, the majority of us choose sure Rs.900 in problem 1 and second option while it comes to problem 2. We performed risk-averse behavior during problem 1 but risk-taker during problem 2. Here, also we neglect probabilities, we get fearless when we have the option to zero loss. And above zero, we will have fear.
The (negative) value of losing Rs.900 is much more than 90% of the (negative) value of losing Rs.1,000. The sure loss is very aversive, and this drives you to take the risk.
But when we do mathematics then only, we can understand that both options in both the problems are similar.
Getting Rs.900 for sure or Rs.900 which is 90% of Rs.1000. And a loss of Rs.900 or Rs.900 which is 90% of Rs.1000.
Our psychological factors affect us for making such decisions. We differently behave to profit and loss. Here, counter to the utility theory is, – our risk behavior does not get changed with our net worth. we also know that our attitudes to gains and losses are not derived from our evaluation of wealth.
Investment – When we have uncertainty, people fear to invest. But when things start becoming certain everyone rushes for investment. This is a reason why people come to invest when the market is near an all-time high because they get sure that they will not face loss now.
If we focus on probabilities then we can make a wise and rational decision that helps us to progress further. We should assign probabilities to the occurrence of different events so that we have statistical support to make a wise decision rather than just make it with support from emotions.
This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.