Gambling Our Way Out of Losses

This issue is the third in the series about bad financial decisions, as discussed in the book, "It's NOT an OPTION" by Jon and Pete Najarian.

Read the first issue, "Why Do You Make Bad Financial Decisions."

We sometimes make bizarre financial choices. If I owe you $500 and you agree to choose between A) I pay you $500, and B) you flip a coin, if heads, I pay you $1,000, and if tails, you get nothing. Which would you choose?

Mathematically, A and B have an Expected Value of $500. In other words, if you make both choices hundreds of times, you would be expected to end up with $500 in both cases. A is worth $500 for sure, while B is worth $500 on average. The two choices have the same $500 average, but B has a risk: you may get $1,000 or nothing.

Refer to the Diminishing Returns graph in the second issue, Why We Keep Making Bad Financial Decisions. Because going to $500 from $0 is more valuable than going to $1,000 from $500, you'd pick A just like most people did. That is no surprise. The surprise is in the reversed scenario. Suppose you owe me $500. Either A) pay me $500 or B) flip a coin and pay me $1,000 if heads, and you don't pay me anything if tails. Now, which one would you choose? 

The researchers believed if people don't like risk, they will choose A. Surprisingly, most respondents chose to gamble with choice B. People are risk-averse with gains but risk-seeking with losses. Why is this the case? If you understand the perception of money and refer to the Diminishing Returns graph, you'll realize that A is more painful than B. Your starting point is having some money, the $500, and ending with $0. Remember that if going from $0 to $500 creates more "satisfaction," then going from $500 to $0 causes more "pain." The first $500 is worth more than the second $500, so it makes sense to gamble the second $500 to save the first $500.

Researchers tried to quantify, for most people, how much money is required to make the bet. They found out that it is a factor of two. People will bet if the gain is twice as much as what can be lost. It is the same as saying that the money they already have is more valuable than the money they may win.

The danger to look out for is that people hate losing, such that it overcomes their aversion to risk. People are willing to gamble to get out of a losing situation and will take more risks than they would usually take. When that mentality prevails in investing or trading, it can be very destructive.