Human beings hate to lose more than they love to win. This observation explains a range of human behaviour and is central to the field of behavioural economics. It also illustrates the fundamentally irrational way that people approach decisions about their money. Simply put, most of us would choose to keep what we have instead of risking it for something more, in a highly predictable way.
Behavioural scientists refer to this phenomenon as ‘prospect theory’. They have even computed the ratio at which most human beings are more likely to take a gamble than keep what they have. You’d have to offer at least 2.5 times more as a reward than what is being gambled. So someone will not spend R100 on a bet unless they can win at least R350 in return – even if the chances of winning are very high. Across many studies the multiplier for returns always has to be somewhere between 2 and 3 for almost everyone.
The emotional tail wags the rational dog.
Prospect theory also impacts on our decisions surrounding investing. We’ve spoken to many 22seven customers who spend more on insurance than they do on investments. This makes sense in terms of the theory; that we’d spend more protecting what we have than we would on generating more for the future.
As with many of the behaviours we have evolved surrounding resources, this is something that can become a problem for our personal finances. It may have made sense when we were living in small bands and tribes where losses were potentially high for our food and other stores, but not in the modern world where the chances of loss are less significant.
In investing the returns are sometimes difficult to understand. People hear that they could earn 7% per year on a low-risk investment and don’t realise that, thanks to compounding, this would lead to them doubling their money in ten years. Our flawed assessment of the risk versus reward tells us that we should hang on to what we have – but the truth is that we’re missing out.
Psychologist, author and nobel laureate Daniel Kahneman was one of the first scientists to study prospect theory as a foundation of behavioural economics. In the video below this post he explains the basic understanding of the principle.
People hate losing much more than they like winning.
How does prospect theory explain some of your behaviour? Do you think you do a good job of estimating risk in terms of your decisions and do you usually choose to hang on to what you have instead of using it to get more in the future?