Value Investing

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.

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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