Risk Averse? Try picking between $100,000 or $1,000,000
Consider this: you are walking through the green pastures of Ireland and you come across a leprechaun. Lore states that if you can catch a leprechaun, you get a pot of gold; visions of investing in an IRA float through your head! After a short sprint, you catch the trickster fairy! The leprechaun, feeling a little salty, asks if you want $100,000 right now or do you take a coin flip, a 50% chance, to score $1,000,000? Statistics might indicate you should take the risk. After all, the expected value of one choice is $100,000; the other choice has an expected value of $500,000. Being risk averse is a choice though. So which do you choose?
I found this question on a finance group I follow on Facebook. Surprisingly, it seemed most people would choose the $100,000. Reasons why ranged from standard risk averse tendencies to just having a sure bet. However, one of the most interesting reasons given was that people were poor. A for sure Band-Aid was better than a possible life change. I found this to be highly fascinating!
How Life Choices Make You Risk Averse
The most repeated rationale for why people wanted the $100,000 was because it could affect them now. Paying off debt, or bills, or funding a lackluster retirement – they were all different flavors of the same ice cream. It makes sense. Is money more valuable to the millionaire or the person living paycheck to paycheck? Provided the person living paycheck to paycheck spends the $100,000 rationally and attempts to invest it, the money could provide a means to escape their financial strains. The millionaire has comfort as far as money goes. While $100,000 would be nice, the millionaire can afford the risk of going for it all.
There could also be another explanation for the decision to play conservatively. Research out of Columbia University notes that people choose less risky decisions because of their preference for gains and losses rather than predicting final outcomes. Said differently, people would view our scenario as a guaranteed $100,000 vs a potential to miss out on $100,000 just to make more. Their preference to maintain the status quo leads them to choose the conservative option. This is called the prospect theory. It also ties deeply into the idea of loss aversion – which can be briefly defined as preferring to not lose as opposed to winning (i.e. it’s better to not lose $5 than find $5). Basically, most humans are hard wired to be protective of what they already have, even if they could be better off on a gamble.
The Symbiosis of Psychology and Economics
At its core, economics is just the study of human behavior when outcomes and scarce resources exist. Consequently, it’s no surprise to see psychology papers cited in economic papers! In fact, when I read this little question – about choosing $100,000 or the chance at $1,000,000 – it reminded me of the dollar auction. The gist of the dollar auction is that participants must bid on a dollar in $.05 increments. First place gets the prize, less their bid. Second place must still pay their last bid. The game gets to the point where players are bidding over a dollar to minimize their losses. For instance, Player 1 might bid $1.05 for $1 resulting in a loss of $.05, but it causes Player 2 to now suffer a loss of $1. Now Player 2, seeking to minimize their losses, would now bid $1.10 for $1, so on and so forth.
There are hundreds of these types of games to try and explain human behavior. Most of them are pretty fascinating. Take for instance our little game. If you read about that Columbia research I linked above, you would have seen that people who are risk averse and protective of the status quo are only that way when the status quo is intact. Once their reality has been warped, they actually become the most irrational and risk-loving group. Why? Because of their fear of loss. They lose some amount, so they double down on the small risk that they get it back and then some. That’s even if all of the probability says it won’t happen.
That’s why I try not to judge other people’s finances and debt. It’s hard to imagine what’s going on in someone’s mind; and the science says, people are weird when they’re desperate.
What choice do you make – $100,000 or a shot at $1,000,000? Personally, I roll the dice and go for the gold! The expected value is greater and, personally, I’m not too concerned about my finances. $100,000 would drastically change my life, but not so drastically that I’m forced to take it. I also consider myself more risk loving rather than risk averse. However, I’m also an entrepreneur. It’s basically in the job description.