We are fortunate to have a brilliant CFA here at WrapManager, Doug Hutchinson. At our weekly staff meetings, he has been testing our abilities with financial quizzes. This month, he demonstrates how we make choices given our tolerance for risk.Risk Aversion
Consider and choose A or B for each of the following scenarios:
1. You are asked to choose between getting $800 for sure or an 80% chance of getting $1,000
A.) Getting $800
B.) 80% chance of getting $1,000 (and a 20% chance of getting nothing)
2. You are asked to choose between losing $800 for sure or an 80% chance of losing $1,000
A.) Losing $800
B.) 80% chance of losing $1,000 (and a 20% chance of losing nothing)
Note that the expected outcomes for both questions is equal:
A) $800, B) $1,000 x 0.80 = $800
A) -$800, B) -$1,000 x 0.80 = -$800
Behavioral economists Daniel Kahneman and Amos Tversky1 posed a similar set of questions for a research paper and discovered an interesting behavioral tendency. The majority of respondents answered (A) to Question 1 and also answered (B) to Question 2. This is an odd inconsistency because answer (A) for both questions is consistent with risk averse behavior and answer (B) for both questions is consistent with risk seeking behavior. In other words, respondents chose the sure thing over the gamble in one scenario, but chose the gamble over the sure thing in a different scenario.
Kahneman and Tversky explained that this inconsistency is due to aversion to losses. Participants believed that the chance of losing nothing was worth the risk of losing $1,000 instead of locking in a loss of $800.
Investors can sometimes be difficult to classify as risk averse or risk seeking because the same investor can be risk averse in certain scenarios while being risk seeking in other scenarios.
Our Investment Policy Committee considers scenarios like this and others as we formulate recommendations. If your scenario is similar to the one above and you have questions, please contact us here. We are happy to help you analyze your unique investment scenarios.
Source:
1. Prospect Theory: Analysis of Decision Making Under Risk
This posting is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
