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Kim Basinger, the 80’s sex symbol, was forced to declare bankruptcy and to sell part of a city she had bought for 20 million dollars. Nicolas Cage: the excessive purchase of Lamborghini’s, rare animals and castles led him to squander a fortune of over 150 million dollars, along with two Caribbean islands and numerous yachts.
The ultra-billionaire singer Rod Stewart, after having dinner in a restaurant in Los Angeles, thoroughly checked his bank account, once he was back home. When he noticed he had paid for a bottle of water, though he didn’t consume it, he went back to the restaurant to get his money back. Paul Getty, oil tycoon and billionaire, refused to pay the ransom, when his nephew was kidnapped in 1973 in Italy, until the young boy had his ear cut off.
In Venice, in the 16th century, there was a merchant that made his profits with maritime commerce. To be prudent, he never sent all his ships on the same route, leading them instead in four different directions.
Doing so, he reduced risks: the possibility that the ships would have been hit simultaneously by an adverse event (pirates, storms, diseases), losing the cargo or being destroyed, was dramatically decreased. Every ship had a 1 in 4 chance of not coming back from the trip; the chance that the merchant lost everything and had troubles with the banker that financed him decreased to 1 in 256.
This choice was much different from that of a family of fishermen in Aci Trezza that, to financially sustain themselves, took on credit a batch of mussels to resell on the market. But, during the journey on the sea, the boat shipwrecked because of a storm and the cargo was lost. Pressured by debits, the family was then forced to sell the house too.
Bringing up Shakespeare and Verga, actors, singers and oil tycoons, we have introduced the concept of aversion and inclination to risk: a behavior that changes depending on contexts and the person.
Indeed, a person can be inclined to the risk of driving a car, while being cautious in the stock market, practicing extreme sports, but disliking emotional uncertainty, going frequently to the casino, but meticulously undergoing medical check-ups.
The aversion to risk of the merchant of Venice, of Getty and Rod Stewart is now easily understandable, especially if compared to the troubled fate of Malavoglia, Basinger and Cage.
How do we behave facing risk?
It depends on many factors and the discipline that deals with this is behavioral finance (branch of economic studies that analyze the behaviors of financial markets), founded by the Nobel prize for Economy Daniel Kahneman and his colleague Amos Tversky.
In other words, the loss of a sum, no matter the entity, weighs on our mind, subjectively, much more than the gain of the same sum.
To be precise, the rate of aversion to loss is between 2.25 and 2.5: facing a loss of 100 dollars, it is necessary to gain between 225 and 250 dollars in order for our brain to find peace.
Let’s translate all of this in an example. Imagine you are being summoned to the boss’s office and you are informed of the fact that you will receive a raise of 500 dollars. On a scale from 1 to 10, how high would you rate the positive psychological impact of the news?
Now imagine that you are informed not of a raise, rather a decrease in your salary of 500 dollars. For most people, the negative psychological impact of such news is greater than the positive one tied to a raise.
Not everybody in fact is opposed or inclined to losses in the same way. For example, those that took risks as their job in financial markets tolerate losses in a better way: when the participants of an experiment were asked to “think as a trader”, they became less opposed and their emotional reactions to losses sensibly reduced.
Where do you find yourself?
Probably, you are asking yourselves what your predominant behavior between aversion and inclination to risk is. I will ask you some questions, proposed by Kahneman himself.
Focus only on the subjective influence of the possible loss or gain that derives from answering sincerely:
- Consider an option with a 50-50 chance of losing 10 dollars. What kind of gain makes the option seem inviting?
- What do you think of the possibility of losing 500 dollars with a coin toss? What kind of gain would compensate it?
- What about a loss of 2000 dollars?
Doing this exercise, you will have noticed that your coefficient of aversion to loss tends to increase, even if not by much, as the stakes get higher. No bet would be inviting if the potential loss were disastrous. In such cases, the coefficient of aversion to loss is very high: there are risks that you would never accept, regardless of how many millions you could win if you were lucky. Or is it not the case?
Risk and conditioning
Regardless of our inclination or aversion to risks, what is important is having clear in mind the objectives you want to reach, rather than being led by the emotions of the moment. To obtain better results, being aware of the way aversion to loss or inclination to risk influence our decisions is fundamental.
An error could be imagining the future, basing it on the experiences in the past. The past, sadly, contains information only on the past… and the risk is ending as the Inductivist Turkey of Bertrand Russell and Karl Popper.
Russell poses the example of the turkey that is taken care of with extreme attention and received water and food every day. Gradually, it gets used to the situation and his sense of safety increases. The turkey’s confidence gets greater, until it is abruptly interrupted (and in a tragic way, at least from the turkey’s point of view) on Thanksgiving!
The poor turkey was used by Bertrand Russell to prove the risks of thinking that the past contains all useful information for the future. It is the same risk we encounter too when we try to make predictions (of any kind). In conclusion, we are machines designed to make mistakes… Or better, we are perfectly evolved machines to survive in the natural world, but way less fit to the artificial and complex world of work. Knowing does not save us, but it helps.
- Kahneman D., Tversky A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291.
- Kahneman D., Tversky A. (1981). The framing of decisions and the psychology of choice. Science, 211, 453-458.
- Kahneman D., Tversky A. (2000). Choice, values, and frames. New York: Russell Sage Foundation.
- Russell B., The Problems of Philosophy