3. Cialdini’s
Sharon
“Dear Mother and Dad, Since I left for college I have been remiss in writing
and I am sorry for my thoughtlessness in not having written before.“I will
bring you up to date now, but before you read on, please sit down. You are
not to read any further unless you are sitting down, okay?
4. “Well, then, I am getting along pretty well now. The skull fracture and the
concussion I got when I jumped out the window of my dormitory when it
caught on fire shortly after my arrival here is pretty well healed now...
5. “I only spent two weeks in the hospital and now I can see almost normally
and only get those sick headaches once a day...
6. “Fortunately, the fire in the dormitory, and my jump, was witnessed by an
attendant at the gas station near the dorm, and he was the one who called
the Fire Department and the ambulance...
7. He also visited me in the hospital and since I had nowhere to live because of
the burnt-out dormitory, he was kind enough to invite me to share his
apartment with him. It's really a basement room, but it's kind of cute. He is
a very fine boy, and we have fallen deeply in love and are planning to get
married. We haven't set the exact date yet, but it will be before...
8. ...my pregnancy begins to show. Yes, Mother and Dad, I am pregnant. I
know how much you are looking forward to being grandparents and I know
you will welcome the baby and give it the same love and devotion and
tender care you gave me when I was a child...
9.
10. “The reason for the delay in our marriage is that my boyfriend has a minor
infection which prevents us from passing our premarital blood tests and I
carelessly caught it from him...
11. “I know that you will welcome him into our family with open arms. He is
kind and, although not well educated, he is ambitious...
12. “Now that I have brought you up to date, I want to tell you that there was no
dormitory fire, I did not have a concussion or skull fracture, I was not in the
hospital, I am not pregnant, I am not engaged, I am not infected, and there
is 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.”
19. Decoy
Decoys in comparables
Example of 2nd most expensive wine on the menu - the most expensive is
the decoy which is supposed to make the 2nd most expensive (and very
profitable for the restaurant) wine look better than the cheaper ones and
good value compared to the most expensive one.
20. Buying a Lamp
Buying a Car
In availability bias - this was about anchoring - You were anchoring to price
of lamp and price of car and NOT anchoring to wealth
Here its about contrast - high contrast - the Rs 1000 saving on a lamp
looks BIG but SMALL in a car
21. $15 $15 $15 $15 $15 $95 $95 $150
Experiments show that average wine sales increase substantially by having the $150
bottle listed right next to the $95 bottle. Moreover, the sales increase happens not
because 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 more
desirable.
The way to sell a lot of $800 shoes is to display some $1,200 shoes next to them...
22. Averaging down is a good idea but like most good ideas, if they are carried
to 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 and
worthy of averaging down
23. Catching
a
Falling
Knife
Blind averaging down can cause grave harm if you do it with the wrong kind of stock.
24. Beware of Little Expenses
for A Small Leak will Sink
a great ship
Here is another example…
Small things add up
When compared with a LARGE investment, They LOOK small, but they add
up and become BIG.
27. 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 of
investments compounding at
the same rate.
28. 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?
29. If you put a frog in boiling hot water, it will instantly jump out and escape
30. But if you put a frog in lukewarm water and slowly boil it, it will slowly boil
to death!
While there is no truth to this story whatsoever, the human equivalent of the
boiling frog is there in all of us...
31. “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 a
trend that is destiny.”
32. 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)….
35. “Cognition, misled by tiny changes involving low contrast, will often miss a trend
that 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 of
low contrast are going to MISS IT
Sometimes the light at the end of the tunnel is from an oncoming train!
36. 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 adult
observers. Recognition was delayed when subjects first viewed the pictures
out of focus. The greater or more prolonged the initial blur, the slower the
eventual recognition. Interference may be accounted for partly by the
difficulty of rejecting incorrect hypotheses based on substandard cues.
You need to distance yourself from the noise...
46. Noise Vs.
Signal
"The more frequently you look at data, the more noise you are disproportionally likely to get (rather
than the valuable part called the signal); hence the higher the noise to signal ratio. And there is a
confusion, that is not psychological at all, but inherent in the data itself. Say you look at information
on a yearly basis, for stock prices or the fertilizer sales of your father-in-law’s factory, or inflation
numbers in Vladivostock. Assume further that for what you are observing, at the yearly frequency the
ratio of signal to noise is about one to one (say half noise, half signal) —it means that about half of
changes are real improvements or degradations, the other half comes from randomness. This ratio is
what you get from yearly observations. But if you look at the very same data on a daily basis, the
composition would change to 95% noise, 5% signal. And if you observe data on an hourly basis, as
people 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
47. This is a fantastic description of markets from Ben Graham’s Security Analysis.
Noise vs. Signal
It tells you what you need to IGNORE and what you need to FOCUS on
There are only a FEW things out there that are important. All the rest is NOISE.
53. 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 equivalent
gains
54. The reason you like
the 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.
55. people
become
risk
seeking
when all
their
options
are bad.
56. The Psychology of the Near Miss
DSRS 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 - who
will face more regret
57. “You own a small casino in Las Vegas. It has fifty standard slot machines which are identical
in appearance. “Moreover, they have exactly the same payout ratios. The probability of
hitting a jackpot is identical in all of them and they amount of money won in case of a
jackpot is also the same. “But there’s one slot machine in this group that, no matter where
you put it among the fifty, produces 25% more winnings for the casino at the end of the
every day. “What is different about that heavy winning slot machine?
58. 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 “lose
something?”
They become gamblers…
Combines with Overconfidence
59. In a game of skill, like shooting, a near miss gives useful feedback and
encourages the player by indicating that success may be within reach
60. What will happen if slot machines and instant lotteries are contrived to
ensure a higher frequency of near misses than would be expected by
chance alone?
61. Near misses in random situations fool people into “trying harder” next time
62. 361204 965304 865305
winning lottery number is 865304
The owner of which ticket is likely to “try harder” next time?
You’ve got to learn how to deal with losses in life (personal and
professional). One way to do that is to invert. Try to re-frame the problem
from a loss frame to a gain frame to de-bias yourself.
63. Countdown effect
Volumes rise during the last few minutes of trading. Why?
“I am going to lose this opportunity to buy (sell) this stock because it would open
higher (lower) tomorrow morning. Therefore I am going to behave like the man who
when approaching a traffic crossing sees the light turn yellow from green…”
The fellow who was contemplating selling is worried the stock will open even lower
yesterday and does not want to wait until tomorrow. He reduces his price and sells
the stock.
64. From Cialdini’s Influence:
“There is something almost physical about the desire to have a contested item. Shoppers at
big close-out or bargain sales report being caught up emotionally in the event. Charged by
the crush of competitors, they swarm and struggle to claim merchandise they would
otherwise disdain.”
65. “Such behavior brings to mind the “feeding frenzy” of wild, indiscriminate eating among
animal groups. Commercial fishermen exploit this phenomenon by throwing a quantity of
loose bait to large schools of certain fish. Soon the water is a roiling expanse of thrashing
fins and snapping mouths competing for the food. At this point, the fishermen save time and
money by dropping unbaited lines into the water, since the crazed fish will bite ferociously at
anything now, including bare metal hooks.”
66. “There is a noticeable parallel between the ways that commercial fishermen and department
stores generate a competitive fury in those they wish to hook. To attract and arouse the
catch, fishermen scatter some loose bait called chum. For similar reasons, department stores
holding a bargain sale toss out a few especially good deals on prominently advertised items
called loss leaders. If the bait, of either form, has done its job, a large and eager crowd
forms 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 what
they want and begin striking at whatever is being contested.”
67. 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 a
remarkable 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 television
showing 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, the
payment 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 their
money 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: It
was 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 in
quite 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 have
been 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 if
it 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 instructive
are 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 the
movie 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.”
68. 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 learned
something 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 man
was the one who had lost the highly sought-after prize. As a general rule, whenever the dust settles and we find losers
looking and speaking like winners (and vice versa), we should be especially wary of the conditions that kicked up the
dust—in the present case, open competition for a scarce resource. As the TV executives now know, extreme caution is
advised 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 cases
involving direct competition, the blood comes up, the focus narrows, and emotions rise. As this visceral current
advances, the cognitive, rational side retreats. In the rush of arousal, it is difficult to be calm and studied in our
approach. As CBS Television’s president, Robert Wood, commented in the wake of his Poseidon adventure, “You get
caught up in the mania of the thing, the acceleration of it. Logic goes right out the window.”
69. “In many of these
acquisitions,
managerial intellect
wilted in competition
with managerial
adrenaline The thrill
of the chase blinded
the pursuers to the
consequences of the
catch.”- Warren
Buffett
70.
71. 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 ancestors
lived in the caves. But modern world is different….
72. Basic
Instinct
Neuroeconomics shows that financial losses and mortal danger are processed in the same
part of the brain: Amygdala
Game: 3 types of subjects were chosen to play a game: normal brains, damaged
amygdalas, brains damaged in areas other than amygdala (controls). Each player was given
a starting capital of $20 and was then offered a choice to play a game or not. The game
involved a coin toss. To play the game one had to invest $1
73. 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 but
overall result in 20 rounds is expected to in your favor.
78. “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 modern
industrialized society differs systematically from the world of our ancestors, we tend to
get into trouble.
Our brains, like our bodies, reflect the world of our ancestors. In particular, our lizard
brains are pattern-seeking, backward-looking systems that allowed us to forage
successfully for food and repeat successful behaviors.This system helped our ancestors
survive and reproduce, but financial markets punish such backward-looking decisions.
81. 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 makes
people more or less happy. Jack and Jill have the same wealth, and the theory
therefore asserts that they should be equally happy, but you do not need a
degree 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 had
only 2 million today while she has 5. So Bernoulli’s theory must be wrong.” -
Kahneman
People don’t anchor to wealth. They anchor to CHANGES in wealth.
82. 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
83. 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 sure
You can easily confirm that in terms of final states of wealth—all that matters for Bernoulli’s
theory—problems 3 and 4 are identical. In both cases you have a choice between the same
two options: you can have the certainty of being richer than you currently are by $1,500, or
accept a gamble in which you have equal chances to be richer by $1,000 or by $2,000. In
Bernoulli’s theory, therefore, the two problems should elicit similar preferences.
84. When directly
compared or
weighted
against each
other, losses
loom larger
than gains.
“This asymmetry between the power of positive and negative expectations
or experiences has an evolutionary history. Organisms that treat threats as
more urgent than opportunities have a better chance to survive and
reproduce.” - Kahneman
85. “The quantity of a man’s pleasure from a ten-dollar gain does not exactly match the quantity of his displeasure
from a ten-dollar loss.”
We concluded from many such observations that “losses loom larger than gains” and that people are loss
averse. You can measure the extent of your aversion to losses by asking yourself a question: What is the
smallest 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 in
the range of 1.5 to 2.5.
Professional risk takers in the financial markets are more tolerant of losses, probably because they do not
respond emotionally to every fluctuation. When participants in an experiment were instructed to “think like a
trader,” they became less loss averse and their emotional reaction to losses (measured by a physiological index
of emotional arousal) was sharply reduced.
What are the consequences?
86. “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. Bonds
In real life that usually translates into a preference for fixed-income investments over
stocks. A guaranteed 6 percent or 7 percent annual return from Uncle Sam may seem a
lot more appealing than the “chance” to earn 11 percent or more a year in stocks. But as
we’ll see later on, the dangers of the stock market may not be as important as the
ravages of inflation. So to the extent that you opt for “safe” investments—such as
bonds, annuities, and other fixed-income or life insurance products—over more volatile
but 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.
87. making
concessions
hurts
In labor negotiations, it is well understood by both sides that the anchor is the existing
contract and that the negotiations will focus on mutual demands for concessions relative to
that anchor. The role of loss aversion in bargaining is also well understood: making
concessions hurts.
Loss aversion creates an asymmetry that makes agreements difficult to reach. Status Quo
Bias
“The concessions you make to me are my gains, but they are your losses; they cause you
much more pain than they give me pleasure. Inevitably, you will place a higher value on them
than 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!”
88. “Negotiations over a shrinking pie are especially difficult, because they
require an allocation of losses. People tend to be much more easygoing
when they bargain over an expanding pie.”
89. In the world of territorial animals, this principle explains the success of
defenders. When a territory holder is challenged by a rival, the owner
almost always wins the contest.
91. 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” of
companies, or rationalizing a bureaucracy. As initially conceived, plans for reform almost always
produce many winners and some losers while achieving an overall improvement. If the affected parties
have any political influence, however, potential losers will be more active and determined than potential
winners; the outcome will be biased in their favor and inevitably more expensive and less effective than
initially planned. Reforms commonly include grandfather clauses that protect current stake-holders—for
example, when the existing workforce is reduced by attrition rather than by dismissals, or when cuts in
salaries and benefits apply only to future workers.
Loss aversion favors minimal changes from the status quo in the lives of both institutions and
individuals.
93. 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 $500,000
If you are like most other people, you preferred the left-hand option in problem A and you preferred the right-hand option in
problem B. If these were your preferences, you have just committed a logical sin and violated the rules of rational choice.
Problem A
0.61 × 520000 = 317,200
0.63 × 500000 = 315,000
First choice is better by 2,200
Problem B
0.98 × 520000 = 509,600
1.00 x 500,000 = 500,000
First choice is better by 9,600
This pattern of choices does not make logical sense, but a psychological explanation is readily available: the certainty effect is at
work. The 2% difference between a 100% and a 98% chance to win in problem B is vastly more impressive than the same
difference between 63% and 61% in problem A
95. You can see that the decision weights are identical to the corresponding probabilities at the
extremes: both equal to 0 when the outcome is impossible, and both equal to 100 when the
outcome is a sure thing. However, decision weights depart sharply from probabilities near
these points. At the low end, we find the possibility effect: unlikely events are considerably
overweighted. For example, the decision weight that corresponds to a 2% chance is 8.1. If
people conformed to the axioms of rational choice, the decision weight would be 2—so the
rare event is overweighted by a factor of 4. The certainty effect at the other end of the
probability scale is even more striking. A 2% risk of not winning the prize reduces the utility
of the gamble by 13%, from 100 to 87.1.
You should trade against people who price risk emotionally.
96. 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 a
surgical disaster rather than a financial gain. Compare the intensity with which you focus on
the faint sliver of hope in an operation that is almost certain to be fatal, compared to the fear
of a 1% risk. The combination of the certainty effect and possibility effects at the two ends of
the probability scale is inevitably accompanied by inadequate sensitivity to intermediate
probabilities.You can see that the range of probabilities between 5% and 95% is associated
with a much smaller range of decision weights (from 13.2 to 79.3), about two-thirds as
much as rationally expected.
97. Probabilities that are extremely low or high (below 1% or above 99%) are a special case. It is
difficult to assign a unique decision weight to very rare events, because they are sometimes
ignored altogether, effectively assigned a decision weight of zero - Utter Neglect. Recall
Availability Bias
On the other hand, when you do not ignore the very rare events, you will certainly overweight
them. Most of us spend very little time worrying about nuclear meltdowns or fantasizing about
large inheritances from unknown relatives. However, when an unlikely event becomes the focus of
attention, we will assign it much more weight than its probability deserves. - Excessive
Overreaction in Availability Bias.
Rare events get mispriced. Buffett specializes in pricing rare events by selling overpriced insurance
to worried buyers of insurance.
98. These people are protesting against the commissioning of a Nuclear Power Plant in
Coastal India
http://en.wikipedia.org/wiki/Kudankulam_Atomic_Power_Project
When you pay attention to a threat, you worry—and the decision weights reflect how
much you worry. Because of the possibility effect, the worry is not proportional to the
probability of the threat. Reducing or mitigating the risk is not adequate; to eliminate
the worry the probability must be brought down to zero.
100. The Fourfold Pattern
The top row in each cell shows an illustrative prospect. The second row
characterizes the focal emotion that the prospect evokes. The third row indicates
how 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% chance
to win $10,000” and “$9,500 with certainty”). Choices are said to be risk averse if
the sure thing is preferred, risk seeking if the gamble is preferred. The fourth row
describes the expected attitudes of a defendant and a plaintiff as they discuss a
settlement of a civil suit.
101. 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 prospects
with a substantial chance to achieve a large gain. They are willing to accept less than the expected value
of 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 trial
is going very well and your lawyer cites expert opinion that you have a 95% chance to win outright, but
adds the caution, “You never really know the outcome until the jury comes in.” Your lawyer urges you to
accept a settlement in which you might get only 90% of your claim. You are in the top left cell of the
fourfold pattern, and the question on your mind is, “Am I willing to take even a small chance of getting
nothing at all? Even 90% of the claim is a great deal of money, and I can walk away with it now.”
102. The possibility effect in the bottom left cell explains why lotteries are popular. When the top prize is very
large, ticket buyers appear indifferent to the fact that their chance of winning is minuscule. A lottery
ticket is the ultimate example of the possibility effect. Without a ticket you cannot win, with a ticket you
have a chance, and whether the chance is tiny or merely small matters little. Of course, what people
acquire with a ticket is more than a chance to win; it is the right to dream pleasantly of winning.
103. The bottom right cell is where insurance is bought. People are willing to pay much more for insurance
than expected value—which is how insurance companies cover their costs and make their profits. Here
again, people buy more than protection against an unlikely disaster; they eliminate a worry and
purchase peace of mind.
This is Buffett’s speciality. He sells overpriced insurance to people in this cell.
104. Many unfortunate human situations unfold in the top right cell. This is where people who face very bad
options take desperate gambles, accepting a high probability of making things worse in exchange for a
small hope of avoiding a large loss. Risk taking of this kind often turns manageable failures into
disasters. The thought of accepting the large sure loss is too painful, and the hope of complete relief too
enticing, to make the sensible decision that it is time to cut one’s losses. This is where businesses that
are 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 which
the 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 where
people who think “I have too much invested in this, and I can’t afford to write it off now” live.
105. desperate fears
after losing a lot
of money induces
people to take
enormous risks
with the rest of
their money -
Gambler’s ruin
Many gamblers stake everything thats left of their bankroll on the riskiest of
the bets - which obviously offer the highest payouts - just to “get back in
the game”
Why can’t people afford to write off their losses?
106. "The combination of loss aversion and narrow framing is a costly curse. Individual investors can avoid that curse, achieving the
emotional benefits of broad framing while also saving time and agony, by reducing the frequency with which they check how
well their investments are doing. Closely following daily fluctuations is a losing proposition, because the pain of the frequent
small losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough, and may be more than enough
for 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 increased
loss aversion. Investors who get aggregated feedback receive such news much less often and are likely to be less risk averse
and to end up richer. You are also less prone to useless churning of your portfolio if you don't know how every stock in it is
doing every day (or every week or even every month). A commitment not to change ones position for several periods (the
equivalent 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.
107. One day in the early eighties, Warren Buffett joined a few friends for a game of golf. The men did a
lot 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 the
weekend. 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, almost
a billionaire- would be so tight and began to make fun of him for it. Buffett, grinning, noted that
he measured an $11 wager exactly as he would $11 million. He kept his wallet tightly zipped.
108. 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 cost
of losing $100. How do you feel about it? For most people, the fear of losing $100 is more intense than the
hope of gaining $150.
Although the expected value of the gamble is obviously positive, because you stand to gain more than you can
lose, 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.
109. 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 small
favorable gamble that you will ever consider? Of course, you are unlikely to be offered
exactly this gamble again, but you will have many opportunities to consider attractive
gambles with stakes that are very small relative to your wealth. You will do yourself a large
financial favor if you are able to see each of these gambles as part of a bundle of small
gambles and rehearse the mantra that will get you significantly closer to economic
rationality: you win a few, you lose a few. The main purpose of the mantra is to control your
emotional response when you do lose. If you can trust it to be effective, you should remind
yourself of it when deciding whether or not to accept a small risk with positive expected
value.” - Kahneman
110. “If you have the emotional discipline that this rule requires, you will never
consider a small gamble in isolation or be loss averse for a small gamble
until you are actually on your deathbed—and not even then.” - Kahneman.
What did he mean by those last three words?
Think about it...
