Double or Nothing
Consider this wager on a coin toss: Heads - you win $20; tails - you lose $20. Would you take this gamble? By the way, you won $100 earlier, and now you are faced with this coin toss wager. Now would you take this gamble? Did your answer change? fl poraon who has m mfo peace wilh Hs What if you had lost accept gamWes lhal
$20 earlier? How does W(U(d be uiacceptable to Km otherwisa
the gamble look now? Danje| Kahieman and flmos ^^1
You may gamble in one situation but not in a different situation. The odds of winning the $20 do not change in the different situations. Neither do the risk and the reward. Therefore, it must be your reaction to risk and reward that changes between the scenarios.
People seem to use a past outcome as a factor in evaluating a current risky decision. In short, people are willing to take more risk after gains and less risk after losses. To illustrate this behavior, consider the responses of 95 economics students to a series of two-step gambles using real money.2 In the first step, money was either given to or taken from the student. In the second step, the student was asked whether he or she wished to take the gamble presented. The findings suggest that the students were motivated by one of three biases when it came to answering this question: the house-money effect, the snake-bite (or risk-aversion) effect, and the break-even effect.
HOUSE-MONEY EFFECT
After people have experienced a gain or profit, they are willing to take more risk. Gamblers refer to this feeling as playing with the house's money. After winning a big profit, amateur gamblers don't fully consider the new money as
their own. Are you willing to take more risk with your opponent's money or your own money? Since gamblers don't fully integrate their winnings with their own money, they act like they are betting with the casino's money. Professional gamblers probably do not suffer from this bias. One of the characteristics that makes you able to successfully gamble (or trade stocks) for a living is the ability to overcome emotional biases.
You have just won $15. Now you are faced with the opportunity to bet $4.50 on a coin toss. Do you place the bet? Seventy-seven percent of the economics students placed the bet. After just receiving
dents were willing to take risk. |
People are more willing to take financial their windM1 of $15> most stu
risk after a windfall profit even when not ordinarily inclined to take risk. 0n the other hand> when students were asked to place a bet on a coin toss without receiving the $15, only 41% chose the gamble.
The house-money effect predicts that you are more likely to buy risky stocks after closing out a successful position. That is, after locking in a gain by selling stock at a profit, you are more likely to buy higher risk stocks. Note that this behavior magnifies the overconfidence behavior of Chapters 2 and 3 because overconfident investors trade too much and buy higher risk stocks.
SNAKE-BIT (RISK-AVERSION) EFFECT
After experiencing a financial loss, people become less willing to take risk. This is the snake-bit or risk-aversion effect. When faced with a gamble after already losing money, people generally choose to decline the gamble. Students who initially lost $7.50 were then asked to wager $2.25 on the flip of a coin. This time, the majority (60%) declined the gamble. After losing the initial money, the students may have felt snake bit.
Snakes don't often bite people, but when it occurs the person becomes more cautious.
The snake-bit effect can also affect your investing. New or conservative investors may decide to give the stock market a try. Adding some stocks to a portfolio gives the long-term investor better diversification and higher expected returns. However, if those stocks quickly fall in price, the first-time stock investor may feel snake bit. Consider the young client of financial consultant Norma Mannix,who started by buying shares of a biotechnology company at $30 per share. Three days later the stock fell to $28 and she panicked and sold the stock. Later the stock went up to $75, "but she's afraid to get back in the market."3
In the long term, it is harmful to your wealth if being snake bit
causes you to avoid the stock market entirely. However, your snake-bit response may be help
After having been unlucky enough to lose money,
tul it it occurs when you
7 people often feel that they will continue to be
are buying IPOs or penny
unlucky Therefore, they avoid risk
stocks. It these investments are not appropriate for you, being snake bit might cause you to avoid them.
BREAK-EVEN EFFECT
Losers don't always avoid risk. People often jump at a chance to make up their losses. After having lost some money, a majority of the students accepted a double-or-no thing toss of the coin. In fact, a majority of the students were willing to accept a double-or-nothing toss of the coin even when they were told the coin was not "fair." That is, students were willing to take risk even though they knew they had less than a 50% chance of winning. The need for breaking even - the break-even effect - appears to be stronger than the snake-bit effect.
Another example of this break-even effect can be seen at the racetrack. After a day of betting on the horses and losing money, gamblers are more likely to bet on long shots.4 Odds of 15 to 1 mean that a $2 bet would win $30 if the horse wins. Of course, horses with odds of 15 to 1 are unlikely to win. The proportion of money bet on long shots is greater toward the end of the race day than at the beginning of the day. It appears that gamblers are less likely to take this risk at the beginning of the day. However, those gamblers who have won a good deal of money (house-money effect) or who have lost money (break-even effect) during the day are more likely to take this kind of risk. Winners take this risk because they feel like they are playing with the house's money. Losers like the opportunity to break even without risking too much more money. People without significant gains or losses prefer not to take the risk of long shots.
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