Even the most logical among us make mental errors. For most of our normal assessments and decisions, we rely on a more intuitive and emotional kind of thinking. This kind of thinking has in part been built on experience and works great for a good portion of our lives. But your investment decisions don’t fall into this category. To realise this, we start with a couple of questions. Think about each before you continue:
1. Would you rather be given a 50% chance of getting $10,000 or a 100% chance of getting $4,000?
2. Would you rather have a 50% chance of losing $10,000 or a 100% chance of losing $4,000?
Interesting is that for the first question, most people would pick the sure thing and take the $4,000 they didn’t have before. But for the second question, most people would take the risk of possibly losing $10,000 over the certainty of losing $4,000. Why is this?
We have an intuitive, emotional and automatic aversion to risk taking when it comes to a gain. We tend to choose a sure thing over even a 50-50 chance at more than twice the gain. We also have an intuitive, emotional and automatic aversion to losing anything, to giving up anything, even something of little or no value. So if there’s a chance of avoiding a loss, even just a 50% chance and even if we’d be risking more than double that certain loss, we’ll take that chance. This is an emotional tendency that some of the smartest people in the world are drawn to.
Choices like this aren’t fully conscious, of course. They’re automatic. This doesn’t mean the intuitive, emotional part of our thinking is bad. If we had to think consciously through every choice we make throughout the day, we wouldn’t be able to function. The trick is knowing when to stop automatic habits and engage our conscious, rational mind. Making investment decisions is one of those times.
Sven Franssen