A curious phenomenon

On 21 January 2021, the US Mega Millions lottery announced their top prize: a whopping $970 million ^[1]. What are the odds of winning the top prize?

1 in 302 million ^[2].

Despite the near impossibility to win, 50% of adult Americans have played the lottery before ^[2].

People ignore the odds.

Nobel Prize-winning psychologist and economist, Daniel Kahneman, and his co-author Amos Tversky developed the model, Prospect Theory, to explain this strange behavior.

What is Prospect Theory?

Prospect Theory is a decision theory that explains how people’s decisions are influenced by their attitudes toward risk, uncertainty, loss, and gain.

Under the umbrella of Prospect Theory, Kahneman and Tversky pointed out that humans tend to over-estimate the chance of an event happening ^[3]. This observation rides on the research of another Nobel-prize winning economist and cognitive psychologist Herbert Simon who suggested that humans are unable to think objectively due to influences such as information inadequacy, social pressures and individual motivations.

Compounding the human’s poor ability to assess chances (or probabilities) is the universal observation that humans feel the pain of loss more than the joy of gain. Losing five dollars hurts more than chancing upon five dollars causing people to be averse to loss. This loss aversion motivates one to make decisions to avoid the pain associated with loss.

What if there is nothing to lose?

In the lottery context, the only “loss” is the lottery ticket cost, which is negligible for most people as long as they are not compulsive gamblers. The “what if I could have won” notion outweighs the failure to win the lottery, which might be a subconsciously expected outcome anyway. Hence the allure of huge financial upside dominates people’s thinking, even though the likelihood of winning is minute.

When there is too much to lose

Yet, on the other end of the loss spectrum, people’s decision-making process is complicated by options. It is no coincidence that the term “prospect” originally (and aptly) referred to the options available.

If people face two options, one is a near-certain loss while the other a tiny chance of a gain, they become strongly motivated to take the latter option, in the hope of getting the gain and avoiding the pain of loss. In this context, people become risk takers. They go “all-in”.

Entreprenuers frequently display this classic decision-making behavior. In Singapore, it has been reported that many entrepreneurs from the food and beverage industry, despite having incurred losses amounting to millions due to COVID-19 measures restraining operations for over at least twelve months, feel they have no choice but to persist, even dipping into their personal reserves. As some of them remarked, “I can’t stop now because I have already lost so much”  ^[4].

However a different set of options can present the same perception of “much to lose”. Imagine having to choose between two options: To receive a guaranteed winning or to take a chance for a higher winning amount but also accompanied by a slim chance of getting nothing. Most of you would opt for the guaranteed winning. We mentally exaggerate the “slim” chance of getting nothing so much so that the thought of losing something so close at hand is unbearable.

Such loss aversion also means that humans like certainty, so that they can keep a lid on their exposure to chances of loss.

Hence, we buy insurance

Since humans do not resonate well with uncertainty and yet over-estimate low probabilities of a financial loss, it is certainly stressful for us, Homo sapiens. Hence, we rely on insurance to eliminate the uncertainty of looming losses.

We see this in the type of insurance that people prefer to buy. For a peace of mind, consumers would rather pay a higher premium for a policy with complete coverage than a cheaper policy with only partial coverage and an out-of-pocket component that they must pay themselves ^[5].

As we understand how we Homo sapiens are wired to make decisions, it begs the question: What is the end goal of the, somewhat irrational, choices that we make?

We all like a stress-free and happy life

Contrary to popular wisdom, humans do not pursue wealth just for money’s sake. Ultimately, the end goal for most is to be able to cope with any loss-related crises and yet fulfil their aspirations, i.e. a stress-free and happy life on self-defined terms.

In 360F, we recognize that goal, especially on the financial frontier. Hence, our proprietary scoring system known as 360-HappiU^© follows the fundamentals of the Prospect Theory to measure your personal financial satisfaction.

Through 10,000 stochastic simulations, we measure your HappiU^© by stress-testing your financial future against every conceivable personal and market risk so that you can reach your life’s goals while weathering through financial storms.

After all, we all hate to lose.

 

Discuss more?

Drop us an eMail here: clarie.kwa@360f.com

 

Notes

^[1] https://www.cnbc.com/2021/01/21/how-to-up-the-odds-of-winning-a-lottery-harvard-professor.html

^[2] https://news.gallup.com/poll/193874/half-americans-play-state-lotteries.aspx

 ^[3] Kahneman, D. & Tversky, A. (1979). Prospect theory: An analysis of decision under risk by Daniel Kahneman and Amos Tversky. Econometrica. 47(2).

^[4] https://www.channelnewsasia.com/news/singapore/covid-19-phase-2-business-owners-hang-on-losses-15269872

^[5] Johnson, E. J., Hershey, J., Meszaros, J., & Kunreuther, H. (1993). Framing, probability distortions, and insurance decisions. Journal of Risk and Uncertainty. 7(1), 35-51.