The psychology of human misjudgment ii


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The psychology of human misjudgment ii

  1. 1. ThePsychology of HumanMisjudgment- II
  2. 2. Bias # 2Perceptual contrast
  3. 3. Cialdini’s Sharon“Dear Mother and Dad, Since I left for college I have been remiss in writingand I am sorry for my thoughtlessness in not having written before.“I willbring you up to date now, but before you read on, please sit down. You arenot to read any further unless you are sitting down, okay?
  4. 4. “Well, then, I am getting along pretty well now. The skull fracture and theconcussion I got when I jumped out the window of my dormitory when itcaught on fire shortly after my arrival here is pretty well healed now...
  5. 5. “I only spent two weeks in the hospital and now I can see almost normallyand only get those sick headaches once a day...
  6. 6. “Fortunately, the fire in the dormitory, and my jump, was witnessed by anattendant at the gas station near the dorm, and he was the one who calledthe Fire Department and the ambulance...
  7. 7. He also visited me in the hospital and since I had nowhere to live because ofthe burnt-out dormitory, he was kind enough to invite me to share hisapartment with him. Its really a basement room, but its kind of cute. He isa very fine boy, and we have fallen deeply in love and are planning to getmarried. We havent set the exact date yet, but it will be before...
  8. 8. pregnancy begins to show. Yes, Mother and Dad, I am pregnant. Iknow how much you are looking forward to being grandparents and I knowyou will welcome the baby and give it the same love and devotion andtender care you gave me when I was a child...
  9. 9. “The reason for the delay in our marriage is that my boyfriend has a minorinfection which prevents us from passing our premarital blood tests and Icarelessly caught it from him...
  10. 10. “I know that you will welcome him into our family with open arms. He iskind and, although not well educated, he is ambitious...
  11. 11. “Now that I have brought you up to date, I want to tell you that there was nodormitory fire, I did not have a concussion or skull fracture, I was not in thehospital, I am not pregnant, I am not engaged, I am not infected, and thereis no boyfriend. “However, I am getting a “D” in American History and an “F”in Chemistry, and I want you to see those marks in their proper perspective.Your loving daughter, Sharon.”
  12. 12. What will happen if you put this in your mouth and then...
  13. 13. and then you put this in your mouth?
  14. 14. Dan Airely
  15. 15. Dan Airely
  16. 16. DecoyDecoys in comparablesExample of 2nd most expensive wine on the menu - the most expensive isthe decoy which is supposed to make the 2nd most expensive (and veryprofitable for the restaurant) wine look better than the cheaper ones andgood value compared to the most expensive one.
  17. 17. Buying a Lamp Buying a CarIn availability bias - this was about anchoring - You were anchoring to priceof lamp and price of car and NOT anchoring to wealthHere its about contrast - high contrast - the Rs 1000 saving on a lamplooks BIG but SMALL in a car
  18. 18. $15 $15 $15 $15 $15 $95 $95 $150Experiments show that average wine sales increase substantially by having the $150bottle listed right next to the $95 bottle. Moreover, the sales increase happens notbecause of a rise in sales of the $150 bottle but due to a rise in sales of the $95 bottle.The role of the $150 bottle is to act as a decoy to make the $95 bottle appear moredesirable.The way to sell a lot of $800 shoes is to display some $1,200 shoes next to them...
  19. 19. Averaging down is a good idea but like most good ideas, if they are carriedto the extreme, become bad ideas…Blind averaging down can be injurious to your (financial) health.Just because a stock has fallen 80%, doesn’t necessarily make it cheap andworthy of averaging down
  20. 20. Catching a Falling KnifeBlind averaging down can cause grave harm if you do it with the wrong kind of stock.
  21. 21. Beware of Little Expenses for A Small Leak will Sink a great shipHere is another example…Small things add upWhen compared with a LARGE investment, They LOOK small, but they addup and become BIG.
  22. 22. How would the Buy-and Hold Strategy do?
  23. 23. How would the Buy-and Hold Strategy do?
  24. 24. tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession ofinvestments compounding at the same rate.
  25. 25. Is a Rs 10 stock cheaper than a Rs 100 one?Stock splits can’t make people richer?How could exchanging a Rs 100 note for ten Rs 10 notes make you rich?
  26. 26. If you put a frog in boiling hot water, it will instantly jump out and escape
  27. 27. But if you put a frog in lukewarm water and slowly boil it, it will slowly boilto death!While there is no truth to this story whatsoever, the human equivalent of theboiling frog is there in all of us...
  28. 28. “Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny.”“Cognition, misled by tiny changes involving low contrast, will often miss atrend that is destiny.”
  29. 29. Killing Me Softly...Digital camera’s killed the photographic film business.But it did not happen in a day, or a month, or a quarter.It was slow, painful (for films)….
  30. 30. Killing Me Softly...
  31. 31. Killing Me Softly...
  32. 32. “Cognition, misled by tiny changes involving low contrast, will often miss a trendthat is destiny.”You’ve just got to acquire the skill to spot long-term trends - even if they are slow- indeed PARTICULARLY because they are slow because OTHERS who are victims oflow contrast are going to MISS ITSometimes the light at the end of the tunnel is from an oncoming train!
  33. 33. Jerome S. Bruner and Mary C. Potter, “Interference in Visual Recognition,” Science, Vol. 144 (1964), pp. 424-25.Pictures of common objects, coming slowly into focus, were viewed by adultobservers. Recognition was delayed when subjects first viewed the picturesout of focus. The greater or more prolonged the initial blur, the slower theeventual recognition. Interference may be accounted for partly by thedifficulty of rejecting incorrect hypotheses based on substandard cues.You need to distance yourself from the noise...
  34. 34. Figures in Rs. Million
  35. 35. Market Cap: 13,500 cr.Figures in Rs. Million
  36. 36. Figures in Rs. Million
  37. 37. Market Cap: 2,300 cr.Figures in Rs. Million
  38. 38. Market Cap: 13,500 cr. Market Cap: 2,300 cr.Down 83% in 6 years
  39. 39. Look what SAIL looked like in 2002-03.Stock was quoting at Rs 6.In 4 years it went to 150. How did this happen?
  40. 40. It did not happen in a day, or a week, or a month.It would have been missed by those who focus on short term “noise”
  41. 41. The shorter the time frame, the more the randomness.
  42. 42. Noise Vs. Signal"The more frequently you look at data, the more noise you are disproportionally likely to get (ratherthan the valuable part called the signal); hence the higher the noise to signal ratio. And there is aconfusion, that is not psychological at all, but inherent in the data itself. Say you look at informationon a yearly basis, for stock prices or the fertilizer sales of your father-in-law’s factory, or inflationnumbers in Vladivostock. Assume further that for what you are observing, at the yearly frequency theratio of signal to noise is about one to one (say half noise, half signal) —it means that about half ofchanges are real improvements or degradations, the other half comes from randomness. This ratio iswhat you get from yearly observations. But if you look at the very same data on a daily basis, thecomposition would change to 95% noise, 5% signal. And if you observe data on an hourly basis, aspeople immersed in the news and markets price variations do, the split becomes 99.5% noise to .5%signal. That is two hundred times more noise than signal —which is why anyone who listens to news(except when very, very significant events take place) is one step below sucker." - Taleb
  43. 43. This is a fantastic description of markets from Ben Graham’s Security Analysis.Noise vs. SignalIt tells you what you need to IGNORE and what you need to FOCUS onThere are only a FEW things out there that are important. All the rest is NOISE.
  44. 44. Bias # 3Deprival SuperReaction
  45. 45. Rules: 1. Highest bidder wins 2. 2ndText highest bidder also has to pay his bid price to the auctioneer.
  46. 46. Deprival SuperReaction Syndrome (DSRS)
  47. 47. If you deprive me, I’ll have a super reaction!The human equivalent of the dog deprived of his bone is there in all of us
  48. 48. Choose between:85% chance of winning $100 (the gamble) or sure gain of $85 (the sure thing)
  49. 49. Choose between: 85% chance of losing $100 (the gamble) or sure loss of $85 (the sure thing)People tend to accept more risk to avoid losses than to obtain equivalentgains
  50. 50. The reason you likethe idea of gaining$85 and dislike the idea of losing $85 is not that these amounts change your wealth. You just like winning and dislike losing —and you almost certainly dislike losing more than you like winning.
  51. 51. people become risk seekingwhen all their optionsare bad.
  52. 52. The Psychology of the Near MissDSRS also takes place when you almost have something you love and you “lose it” [“near-misses”]Two friends sharing a cab to the airport. both miss their flights - one by just 5 min and one by 30 min - whowill face more regret
  53. 53. “You own a small casino in Las Vegas. It has fifty standard slot machines which are identicalin appearance. “Moreover, they have exactly the same payout ratios. The probability ofhitting a jackpot is identical in all of them and they amount of money won in case of ajackpot is also the same. “But there’s one slot machine in this group that, no matter whereyou put it among the fifty, produces 25% more winnings for the casino at the end of theevery day. “What is different about that heavy winning slot machine?
  54. 54. What SHOULD you do when the light turns yellow?What do yo ACTUALLY do?What happens to people’s risk assessment abilities when are about to “losesomething?”They become gamblers…Combines with Overconfidence
  55. 55. In a game of skill, like shooting, a near miss gives useful feedback andencourages the player by indicating that success may be within reach
  56. 56. What will happen if slot machines and instant lotteries are contrived toensure a higher frequency of near misses than would be expected bychance alone?
  57. 57. Near misses in random situations fool people into “trying harder” next time
  58. 58. 361204 965304 865305 winning lottery number is 865304The owner of which ticket is likely to “try harder” next time?You’ve got to learn how to deal with losses in life (personal andprofessional). One way to do that is to invert. Try to re-frame the problemfrom a loss frame to a gain frame to de-bias yourself.
  59. 59. Countdown effectVolumes rise during the last few minutes of trading. Why?“I am going to lose this opportunity to buy (sell) this stock because it would openhigher (lower) tomorrow morning. Therefore I am going to behave like the man whowhen approaching a traffic crossing sees the light turn yellow from green…”The fellow who was contemplating selling is worried the stock will open even loweryesterday and does not want to wait until tomorrow. He reduces his price and sellsthe stock.
  60. 60. From Cialdini’s Influence:“There is something almost physical about the desire to have a contested item. Shoppers atbig close-out or bargain sales report being caught up emotionally in the event. Charged bythe crush of competitors, they swarm and struggle to claim merchandise they wouldotherwise disdain.”
  61. 61. “Such behavior brings to mind the “feeding frenzy” of wild, indiscriminate eating amonganimal groups. Commercial fishermen exploit this phenomenon by throwing a quantity ofloose bait to large schools of certain fish. Soon the water is a roiling expanse of thrashingfins and snapping mouths competing for the food. At this point, the fishermen save time andmoney by dropping unbaited lines into the water, since the crazed fish will bite ferociously atanything now, including bare metal hooks.”
  62. 62. “There is a noticeable parallel between the ways that commercial fishermen and departmentstores generate a competitive fury in those they wish to hook. To attract and arouse thecatch, fishermen scatter some loose bait called chum. For similar reasons, department storesholding a bargain sale toss out a few especially good deals on prominently advertised itemscalled loss leaders. If the bait, of either form, has done its job, a large and eager crowdforms to snap it up. Soon, in the rush to score, the group becomes agitated, nearly blinded,by the adversarial nature of the situation. Humans and fish alike lose perspective on whatthey want and begin striking at whatever is being contested.”
  63. 63. From Cialdini’s Influence:“Lest we believe that the competition-for-limited-resources-fever occurs only in such unsophisticated forms of life as tuna and bargain-basement shoppers, we should examine the story behind aremarkable purchase decision made in 1973 by Barry Diller, who was then vice president for prime-time programming at the American Broadcasting Company, but who has since been labeled the“miracle mogul” by Time magazine in reference to his remarkable successes as head of Paramount Pictures and the Fox Television Network. He agreed to pay $3.3 million for a single televisionshowing of the movie The Poseidon Adventure. The figure is noteworthy in that it greatly exceeded the highest price ever previously paid for a one-time movie showing: $2 million for Patton. In fact, thepayment was so excessive that ABC figured to lose $1 million on the Poseidon showing. As NBC vice president for special programs Bill Storke declared at the time, “There’s no way they can get theirmoney back, no way at all.How could an astute and experienced businessman like Diller go for a deal that would produce an expected loss of a million dollars? The answer may lie in a second noteworthy aspect of the sale: Itwas the first time that a motion picture had been offered to the networks in an open-bid auction. Never before had the three major commercial networks been forced to battle for a scarce resource inquite this way. The novel idea of a competitive auction was the brainchild of the movie’s flamboyant showman-producer, Irwin Allen, and a 20th Century Fox vice president, William Self, who must havebeen ecstatic about the outcome. But how can we be sure that it was the auction format that generated the spectacular sales price rather than the blockbuster quality of the movie itself?Some comments from the auction participants provide impressive evidence. First came a statement from the victor, Barry Diller, intended to set future policy for his network. In language sounding as ifit could have escaped only from between clenched teeth, he said, “ABC has decided regarding its policy for the future that it would never again enter into an auction situation.” Even more instructiveare the remarks of Diller’s rival, Robert Wood, then president of CBS Television, who nearly lost his head and outbid his competitors at ABC and NBC: We were very rational at the start. We priced themovie out, in terms of what it could bring in for us, then allowed a certain value on top of that for exploitation. But then the bidding started. ABC opened with two million. I came back with two point four.ABC went to two point eight. And the fever of the thing caught us. Like a guy who had lost his mind, I kept bidding. Finally, I went to three point two; and there came a moment when I said to myself,“Good grief, if I get it, what the heck am I going to do with it?” When ABC finally topped me, my main feeling was relief. It’s been very educational.”
  64. 64. According to interviewer Bob MacKenzie, when Wood made his “It’s been very educational” statement, he was smiling.We can be sure that when ABC’s Diller made his “never again” announcement, he was not. Both men had clearly learnedsomething from the “Great Poseidon Auction.” But for one, there had been a $1 million tuition charge. Fortunately,there is a valuable but drastically less expensive lesson here for us, too. It is instructive to note that the smiling manwas the one who had lost the highly sought-after prize. As a general rule, whenever the dust settles and we find loserslooking and speaking like winners (and vice versa), we should be especially wary of the conditions that kicked up thedust—in the present case, open competition for a scarce resource. As the TV executives now know, extreme caution isadvised whenever we encounter the devilish construction of scarcity plus rivalry.When we watch something we want become less available, a physical agitation sets in. Especially in those casesinvolving direct competition, the blood comes up, the focus narrows, and emotions rise. As this visceral currentadvances, the cognitive, rational side retreats. In the rush of arousal, it is difficult to be calm and studied in ourapproach. As CBS Television’s president, Robert Wood, commented in the wake of his Poseidon adventure, “You getcaught up in the mania of the thing, the acceleration of it. Logic goes right out the window.”
  65. 65. “In many of these acquisitions, managerial intellectwilted in competition with managerial adrenaline The thrillof the chase blinded the pursuers to theconsequences of the catch.”- Warren Buffett
  66. 66. Fear of losing something possessed, or something not possessed but almost possessed.Its processed in amygdala - part of the innermost brain.Basic Instinct - part of our genome“Run away when you sense danger” had a huge survival advantage when your ancestorslived in the caves. But modern world is different….
  67. 67. Basic InstinctNeuroeconomics shows that financial losses and mortal danger are processed in the samepart of the brain: AmygdalaGame: 3 types of subjects were chosen to play a game: normal brains, damagedamygdalas, brains damaged in areas other than amygdala (controls). Each player was givena starting capital of $20 and was then offered a choice to play a game or not. The gameinvolved a coin toss. To play the game one had to invest $1
  68. 68. Heads, you lose $1 Tails, you win $2.5 Total number of rounds: 20 What would you do?You’d play all the rounds. Odds is heavily loaded - you may lose a few rounds butoverall result in 20 rounds is expected to in your favor.
  69. 69. Damaged amygdalas played 84% of the rounds Normals played 63% Controls played 61%Why???
  70. 70. Damaged amygdalas did much better than the other two groups!This does not mean that to be rational you have to experience brain damage :-)
  71. 71. Fear of losing our MTMprofits makes us sell out of good decisions too early.The stupidity of “you can’tgo broke taking a profit.”
  72. 72. Reptilian orlizard brain
  73. 73. “lizard brain” describes the older, more emotional parts of the human brain. The lizard brain is the most important driver of market irrationality, and it is completely ignored by traditional finance and economics.We are built to solve the problems faced by our ancestors. Because modernindustrialized society differs systematically from the world of our ancestors, we tend toget into trouble.Our brains, like our bodies, reflect the world of our ancestors. In particular, our lizardbrains are pattern-seeking, backward-looking systems that allowed us to foragesuccessfully for food and repeat successful behaviors.This system helped our ancestorssurvive and reproduce, but financial markets punish such backward-looking decisions.
  74. 74. framingHow would you frame requests DSRS
  75. 75. Regular bulbs vs. CFL
  76. 76. Today Jack and Jill each have a wealth of 5 million. Yesterday, Jack had 1 million and Jill had 9 million. Are they equally happy? (Do they have the same utility?)“Bernoulli’s Utility theory assumes that the utility of their wealth is what makespeople more or less happy. Jack and Jill have the same wealth, and the theorytherefore asserts that they should be equally happy, but you do not need adegree in psychology to know that today Jack is elated and Jill despondent.Indeed, we know that Jack would be a great deal happier than Jill even if he hadonly 2 million today while she has 5. So Bernoulli’s theory must be wrong.” -KahnemanPeople don’t anchor to wealth. They anchor to CHANGES in wealth.
  77. 77. In addition to whatever you own, you have been given $1,000.You are now asked to choose one of these options: 50% chance to win $1,000 OR get $500 for sure
  78. 78. In addition to whatever you own, you have been given $2,000. You are now asked to choose one of these options: 50% chance to lose $1,000 OR lose $500 for sureYou can easily confirm that in terms of final states of wealth—all that matters for Bernoulli’stheory—problems 3 and 4 are identical. In both cases you have a choice between the sametwo options: you can have the certainty of being richer than you currently are by $1,500, oraccept a gamble in which you have equal chances to be richer by $1,000 or by $2,000. InBernoulli’s theory, therefore, the two problems should elicit similar preferences.
  79. 79. When directly compared or weighted against each other, losses loom larger than gains.“This asymmetry between the power of positive and negative expectationsor experiences has an evolutionary history. Organisms that treat threats asmore urgent than opportunities have a better chance to survive andreproduce.” - Kahneman
  80. 80. “The quantity of a man’s pleasure from a ten-dollar gain does not exactly match the quantity of his displeasurefrom a ten-dollar loss.”We concluded from many such observations that “losses loom larger than gains” and that people are lossaverse. You can measure the extent of your aversion to losses by asking yourself a question: What is thesmallest gain that I need to balance an equal chance to lose $100? For many people the answer is about $200,twice as much as the loss. The “loss aversion ratio” has been estimated in several experiments and is usually inthe range of 1.5 to 2.5.Professional risk takers in the financial markets are more tolerant of losses, probably because they do notrespond emotionally to every fluctuation. When participants in an experiment were instructed to “think like atrader,” they became less loss averse and their emotional reaction to losses (measured by a physiological indexof emotional arousal) was sharply reduced.What are the consequences?
  81. 81. “Being overly sensitive to loss leads people to opt for a certain gain over one that offers a high possibility of a larger gain.”- Daniel Kahneman Stocks Vs. BondsIn real life that usually translates into a preference for fixed-income investments overstocks. A guaranteed 6 percent or 7 percent annual return from Uncle Sam may seem alot more appealing than the “chance” to earn 11 percent or more a year in stocks. But aswe’ll see later on, the dangers of the stock market may not be as important as theravages of inflation. So to the extent that you opt for “safe” investments—such asbonds, annuities, and other fixed-income or life insurance products—over more volatilebut higher-paying ones, your loss aversion may be costing you a lot of money.”Those 400 basis points make hell of a lot of difference.
  82. 82. making concessions hurtsIn labor negotiations, it is well understood by both sides that the anchor is the existingcontract and that the negotiations will focus on mutual demands for concessions relative tothat anchor. The role of loss aversion in bargaining is also well understood: makingconcessions hurts.Loss aversion creates an asymmetry that makes agreements difficult to reach. Status QuoBias“The concessions you make to me are my gains, but they are your losses; they cause youmuch more pain than they give me pleasure. Inevitably, you will place a higher value on themthan I do. The same is true, of course, of the very painful concessions you demand from me,which you do not appear to value sufficiently!”
  83. 83. “Negotiations over a shrinking pie are especially difficult, because theyrequire an allocation of losses. People tend to be much more easygoingwhen they bargain over an expanding pie.”
  84. 84. In the world of territorial animals, this principle explains the success ofdefenders. When a territory holder is challenged by a rival, the owneralmost always wins the contest.
  85. 85. Turf battles take place in boardroom too
  86. 86. Loss aversion explains much of what happens when institutions attempt to reform themselves.Those who stand to lose will fight harder than those who stand to gain.Loss aversion also explains the difficulty in carrying out “reorganizations” and “restructuring” ofcompanies, or rationalizing a bureaucracy. As initially conceived, plans for reform almost alwaysproduce many winners and some losers while achieving an overall improvement. If the affected partieshave any political influence, however, potential losers will be more active and determined than potentialwinners; the outcome will be biased in their favor and inevitably more expensive and less effective thaninitially planned. Reforms commonly include grandfather clauses that protect current stake-holders—forexample, when the existing workforce is reduced by attrition rather than by dismissals, or when cuts insalaries and benefits apply only to future workers.Loss aversion favors minimal changes from the status quo in the lives of both institutions andindividuals.
  87. 87. Allais’s ParadoxMaurice Allais
  88. 88. In problems A and B, which would you choose? A. 61% chance to win $520,000 OR 63% chance to win $500,000 B. 98% chance to win $520,000 OR 100% chance to win $500,000If you are like most other people, you preferred the left-hand option in problem A and you preferred the right-hand option inproblem B. If these were your preferences, you have just committed a logical sin and violated the rules of rational choice.Problem A0.61 × 520000 = 317,2000.63 × 500000 = 315,000First choice is better by 2,200Problem B0.98 × 520000 = 509,6001.00 x 500,000 = 500,000First choice is better by 9,600This pattern of choices does not make logical sense, but a psychological explanation is readily available: the certainty effect is atwork. The 2% difference between a 100% and a 98% chance to win in problem B is vastly more impressive than the samedifference between 63% and 61% in problem A
  89. 89. Decision WeightsGambles with modest monetary stakes estimates for gains
  90. 90. You can see that the decision weights are identical to the corresponding probabilities at theextremes: both equal to 0 when the outcome is impossible, and both equal to 100 when theoutcome is a sure thing. However, decision weights depart sharply from probabilities nearthese points. At the low end, we find the possibility effect: unlikely events are considerablyoverweighted. For example, the decision weight that corresponds to a 2% chance is 8.1. Ifpeople conformed to the axioms of rational choice, the decision weight would be 2—so therare event is overweighted by a factor of 4. The certainty effect at the other end of theprobability scale is even more striking. A 2% risk of not winning the prize reduces the utilityof the gamble by 13%, from 100 to 87.1.You should trade against people who price risk emotionally.
  91. 91. Possibility Certainty Situation 1: you have a 1% chance to win $1 million. You will know the outcome tomorrow. Situation 2: imagine that you are almost certain to win $1 million, but there is a 1% chance that you will not.The anxiety of the second situation will exceed the hope of the first.The certainty effect is also more striking than the possibility effect if the outcome is asurgical disaster rather than a financial gain. Compare the intensity with which you focus onthe faint sliver of hope in an operation that is almost certain to be fatal, compared to the fearof a 1% risk. The combination of the certainty effect and possibility effects at the two ends ofthe probability scale is inevitably accompanied by inadequate sensitivity to intermediateprobabilities.You can see that the range of probabilities between 5% and 95% is associatedwith a much smaller range of decision weights (from 13.2 to 79.3), about two-thirds asmuch as rationally expected.
  92. 92. Probabilities that are extremely low or high (below 1% or above 99%) are a special case. It isdifficult to assign a unique decision weight to very rare events, because they are sometimesignored altogether, effectively assigned a decision weight of zero - Utter Neglect. RecallAvailability BiasOn the other hand, when you do not ignore the very rare events, you will certainly overweightthem. Most of us spend very little time worrying about nuclear meltdowns or fantasizing aboutlarge inheritances from unknown relatives. However, when an unlikely event becomes the focus ofattention, we will assign it much more weight than its probability deserves. - ExcessiveOverreaction in Availability Bias.Rare events get mispriced. Buffett specializes in pricing rare events by selling overpriced insuranceto worried buyers of insurance.
  93. 93. These people are protesting against the commissioning of a Nuclear Power Plant inCoastal India you pay attention to a threat, you worry—and the decision weights reflect howmuch you worry. Because of the possibility effect, the worry is not proportional to theprobability of the threat. Reducing or mitigating the risk is not adequate; to eliminatethe worry the probability must be brought down to zero.
  94. 94.
  95. 95. The Fourfold PatternThe top row in each cell shows an illustrative prospect. The second rowcharacterizes the focal emotion that the prospect evokes. The third row indicateshow most people behave when offered a choice between a gamble and a sure gain(or loss) that corresponds to its expected value (for example, between “95% chanceto win $10,000” and “$9,500 with certainty”). Choices are said to be risk averse ifthe sure thing is preferred, risk seeking if the gamble is preferred. The fourth rowdescribes the expected attitudes of a defendant and a plaintiff as they discuss asettlement of a civil suit.
  96. 96. when they have to choose between 95% chance to win $10,000” OR “$9,000 with certainty, they will choose $9,000. They will accept unfavorable settlement.The top left is the one that Bernoulli discussed: people are averse to risk when they consider prospectswith a substantial chance to achieve a large gain. They are willing to accept less than the expected valueof a gamble to lock in a sure gain.You are the plaintiff in a civil suit in which you have made a claim for a large sum in damages. The trialis going very well and your lawyer cites expert opinion that you have a 95% chance to win outright, butadds the caution, “You never really know the outcome until the jury comes in.” Your lawyer urges you toaccept a settlement in which you might get only 90% of your claim. You are in the top left cell of thefourfold pattern, and the question on your mind is, “Am I willing to take even a small chance of gettingnothing at all? Even 90% of the claim is a great deal of money, and I can walk away with it now.”
  97. 97. The possibility effect in the bottom left cell explains why lotteries are popular. When the top prize is verylarge, ticket buyers appear indifferent to the fact that their chance of winning is minuscule. A lotteryticket is the ultimate example of the possibility effect. Without a ticket you cannot win, with a ticket youhave a chance, and whether the chance is tiny or merely small matters little. Of course, what peopleacquire with a ticket is more than a chance to win; it is the right to dream pleasantly of winning.
  98. 98. The bottom right cell is where insurance is bought. People are willing to pay much more for insurancethan expected value—which is how insurance companies cover their costs and make their profits. Hereagain, people buy more than protection against an unlikely disaster; they eliminate a worry andpurchase peace of mind.This is Buffett’s speciality. He sells overpriced insurance to people in this cell.
  99. 99. Many unfortunate human situations unfold in the top right cell. This is where people who face very badoptions take desperate gambles, accepting a high probability of making things worse in exchange for asmall hope of avoiding a large loss. Risk taking of this kind often turns manageable failures intodisasters. The thought of accepting the large sure loss is too painful, and the hope of complete relief tooenticing, to make the sensible decision that it is time to cut one’s losses. This is where businesses thatare losing ground to a superior technology waste their remaining assets in futile attempts to catch up.Because defeat is so difficult to accept, the losing side in wars often fights long past the point at whichthe victory of the other side is certain, and only a matter of time.This is the cell in which people who “throw good money after bad” live. It’s where people in denial live.It’s where people who believe in “I have to do whatever it takes to get back in the game” live. It’s wherepeople who think “I have too much invested in this, and I can’t afford to write it off now” live.
  100. 100. desperate fears after losing a lot of money induces people to take enormous risks with the rest of their money - Gambler’s ruinMany gamblers stake everything thats left of their bankroll on the riskiest ofthe bets - which obviously offer the highest payouts - just to “get back inthe game”Why can’t people afford to write off their losses?
  101. 101. "The combination of loss aversion and narrow framing is a costly curse. Individual investors can avoid that curse, achieving theemotional benefits of broad framing while also saving time and agony, by reducing the frequency with which they check howwell their investments are doing. Closely following daily fluctuations is a losing proposition, because the pain of the frequentsmall losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough, and may be more than enoughfor individual investors. In addition to improving the emotional quality of life, the deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes. The typical short-term reaction to bad news is increasedloss aversion. Investors who get aggregated feedback receive such news much less often and are likely to be less risk averseand to end up richer. You are also less prone to useless churning of your portfolio if you dont know how every stock in it isdoing every day (or every week or even every month). A commitment not to change ones position for several periods (theequivalent of locking in an investment) improves financial performance."Recall the ides of signal vs. Noise of Taleb and Graham. Kahneman agrees with both.But what is broad or narrow framing?First, a Buffett story.
  102. 102. One day in the early eighties, Warren Buffett joined a few friends for a game of golf. The men did alot of betting and at one session, Jack Bryne, Chairman of GEICO, proposed a novel side bet. For a"premium" of $11, Bryne would agree to pay $10,000 to anyone who hit a hole-in-one over theweekend. Everyone reached for the cash - everyone, except for Buffett, who coolly calculated that,given the odds, $11 was too high a premium. His pals could not believe that he - by then, almosta billionaire- would be so tight and began to make fun of him for it. Buffett, grinning, noted thathe measured an $11 wager exactly as he would $11 million. He kept his wallet tightly zipped.
  103. 103. You are offered a gamble on the toss of a coin. If the coin shows tails, you lose $100. If the coin shows heads, you win $150. Is this gamble attractive? Would you accept it?To make this choice, you must balance the psychological benefit of getting $150 against the psychological costof losing $100. How do you feel about it? For most people, the fear of losing $100 is more intense than thehope of gaining $150.Although the expected value of the gamble is obviously positive, because you stand to gain more than you canlose, you probably dislike it—most people do. They reject this bet.But what if you were offered this bet a 100 times? Then what will you do?Hmmm...What if you are offered it only once? Let me give you some advice on broad framing vs narrow framing.
  104. 104. Are YOu On Your Deathbed?“I sympathize with your aversion to losing any gamble, but it is costing you a lot of money.Please consider this question: Are you on your deathbed? Is this the last offer of a smallfavorable gamble that you will ever consider? Of course, you are unlikely to be offeredexactly this gamble again, but you will have many opportunities to consider attractivegambles with stakes that are very small relative to your wealth. You will do yourself a largefinancial favor if you are able to see each of these gambles as part of a bundle of smallgambles and rehearse the mantra that will get you significantly closer to economicrationality: you win a few, you lose a few. The main purpose of the mantra is to control youremotional response when you do lose. If you can trust it to be effective, you should remindyourself of it when deciding whether or not to accept a small risk with positive expectedvalue.” - Kahneman
  105. 105. “If you have the emotional discipline that this rule requires, you will neverconsider a small gamble in isolation or be loss averse for a small gambleuntil you are actually on your deathbed—and not even then.” - Kahneman.What did he mean by those last three words?Think about it...
  106. 106. Thank You