Loss aversion and risk-taking

I would describe myself as fairly risk-averse, and I’m not really keen on making gambles where I have a good chance of losing.  Recently though I read Daniel Kahneman’s book “Thinking, Fast and Slow“, about the way we think and make choices.  Daniel Kahneman is a Nobel Prize winning psychologist who has spent his career studying the way our brain thinks, both unconsciously and consciously.  Unsurprisingly, it turns out that I’m not alone in my risk-averse behaviour.  Many people are ‘loss-averse’ – that is, losses loom larger in the mind than gains when we decide how to behave.  Consider the following gamble:

50% chance to lose £200, 50% chance to win £300

Statistically, you would do well to accept the gamble as it has an expected gain of £100.  But, the thought of losing £200 often outweighs that of winning £300, and a large number of people would choose not to take this gamble.  In the case of a single gamble, there’s a binary outcome.  You either gain £300 or you lose £200, there’s no middle ground, and none of us wants to lose £200 because of a choice we willingly made.

However, things change if you are offered the chance to take the gamble multiple times.  Then, it makes much more sense to accept the gamble as over a number of attempts you’d expect the gains to outweigh the losses.  It’s no longer a binary outcome and most people would gain something if they decided to gamble.

Contrived examples such as this one rarely crop up in our lives, but plenty of real-life examples do. Whether it’s investing in the stock-market, buying a new TV or choosing a savings account, there are always possible gains and losses to be weighed up.  Kahneman argues that we should all be less loss-averse when it comes to making decisions as, over our lifetimes, the statistical benefits of betting on the small gain will add up in the same way as for multiple gambles.  He admits though that the hardest part of this policy is controlling our emotional response on the occasions when (not if!) we do lose.

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