Chess, Tulips, And Loss Aversion: The Psychology Of Risk And Reward

There is no denying that humans like to takes risks at times, especially when there is a reward waiting for us at the end of it. Yet, every time we step out of our comfort zone our brain tells us about the fear of us failing while also tempting us with the promise of a reward that makes it all worthwhile. There have been a number of fascinating studies carried out in this area over the years that let us better understand how we handle the internal struggle to decide whether the reward is worth the risk or not.

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

bitcoin bubble BTC price

The Importance of Stress

Stress plays an important in our decision-making skills, as shown in this research document put together by Mara Mather and Nichole R. Lighthall. Their work highlights the fact that our brains process risk and reward differently when under stress, with a gender difference also noted in some of the tests. Indeed, male subjects subjected to stress in the studies performed better when taking risks was the best option but more poorly when risk taking wasn’t so advisable. On the other hand, the female volunteers performed in exactly the opposite way.

The researchers say that “stress triggers additional reward salience”, which affects our decision making. For instance, if you make a bad investment that leads to sleepless nights then this stressful situation could lead to you instinctively looking for high risk / high return investments to help resolve the situation. This is something that is likely to affect other parts of personal life as well. When they need to take decisions under a great deal of stress then it is likely that the reward on offer becomes more important to some people, while others become more risk-adverse.

It is also worth bearing in mind that stress in the US it as high as ever, as a 2017 Harris Poll on behalf of APA showed that over 60% of Americans are stressed about money or work.

Risk and Reward in Games

Some of the most popular games of all time are based on encouraging us to find the perfect balance between risk and reward. Should you buy that extra hotel in Monopoly, attack the King in chess, or raise the stakes at poker? Each of these decisions involves weighing up a number of factors and the best players are more effective at doing this.

For example, in chess a player may start with a solid Queen’s Gambit – an opening that was mentioned in literature as far back as 1490 – or else go for a more complex approach such as the Perenyi Attack. In poker, a tight approach signifies caution, while a loose or aggressive strategy will see the player run more risks. As for gambling – such as horse betting and slots games – before each spin of the reels players have to decide how much to play with, which directly influences possible wins – indeed, players can typically alter both the stake and the amount of paylines they bet on.

See: DRF Legend Steven Crist on Value Investing and Horse Betting

See: Investing Lessons from Chess Prodigy Josh Waitzkin

The same theory applies in investing, which is a type of game after all. Do you jump on the Bitcoin bandwagon due to the billions of dollars in profits that some of the biggest winners have made, knowing that you could be in for a wild ride with future price predictions ranging from $60,000 all the way down to $0. Or do you stick to the calmer approach offered by low interest bank savings accounts or pension funds? If you love gambling and taking risks when playing all types of games then there is a good chance that this aspect of your personality shines thorough in your investment strategy too.

Loss Aversion

An interesting study carried out by psychologists Amos Tversky and Daniel Kahneman and published in 1979 helped the latter to win the Nobel Prize in Economics in 2002. Among their ground-breaking research they looked at a natural cognitive bias that many people have that leads to them gambling in order to avoid a certain loss. They called this loss aversion, as the subject is driven to steer clear of a certain loss even when it may be a better decision than taking on an additional gamble that gives the prospect of a gain but that could lead to higher losses.

This work was added to by the study published by Hersh Shefrin and Meir Statman in 1985, while working as professors at the University of Santa Clara Leavey School of Business. They stated that this loss aversion bias could explain why investors sometimes hold poor investments for too long or cash out on good investments too early. The 2007 U.S. Survey of Consumer Finances confirmed that loss aversion exists at a household level, with lower income families having a lower rate of savings but higher income families not having a correspondingly higher level of savings.

The Herd Behavior and Economic Bubbles

One recognized aspect of the psychology of risk and reward is that of herd behavior. This is the instinct that causes us to follow the crowd and to feel safety in numbers, and it is generally something that only highly successful investors are confident enough to avoid completely. It is this sort of behavior that could help to explain why economic bubbles that appear ridiculous and obvious with hindsight may occur.

For instance, the Dutch tulip mania bubble in the 17th century, in which a single tulip bulb was worth more than a house and 10 times the annual salary of a skilled worker, looks astonishingly naïve to us now. However, people at the time were caught up in the idea of investing in something that was making other people rich and didn’t want to miss out.

A study published in the Journal of Banking & Finance in 2010 showed evidence of herding behavior in advanced stock markets outside of the US and Latin America. Again, this isn’t something that is solely related to investing. The herd behavior is what can lead us to trust what other people think rather than our own instincts. Indeed, this can be one way of dealing with a complex situation in which we are unable to work out for ourselves whether the reward is worth the risk.

Article by Vintage Value Investing




About the Author

VintageValueinvesting
Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…