How we over-estimate risk-The Loss Aversion Cognitive Bias

Written by John Kuder

Table Of Contents

Hi! In this video, we’re gonna tell you about the loss aversion bias. Now we know a lot about how it’s being used on you in marketing by marketers, and how you can protect yourself. So stick around.

Okay, so I’ve got a game for you. Yes, we’re gonna toss a coin. Okay? If we lose, you pay me 10 bucks. Now, how much if you win? How much do you need to win to make it fair?

$20 Bingo! Oh my god, I couldn’t have paid you to do that any better. That was that’s exactly what most people do.

So Daniel Kahneman, Nobel Prize winner ran this test, I think in 1979 when he first named this and that’s exactly what he found; that most people wanted to be rewarded at least 2 times (it was actually 2.3 times) what the potential loss was, even though it’s a 50-50 bet.

So probability would say, you know, you know, $1 more like you know, if you were to lose $10 Then by gaining $11 It’s a winning proposition and over time you make money. Right? Okay.

But people… we have… you just demonstrated a loss aversion bias perfectly. Thank you so much! Thank you so much!

Okay, so this does show up mostly around financial… we didn’t flip a coin. lLoss aversion bias shows up mostly around financial decisions. And the bigger the potential loss, the bigger the perceived risk. The more the more it gets triggered. The more it comes into play.

Oh, he’s a trader. Okay, so perfect introduction. Good. Thank you so much. Well, let’s look at the idea of a bet. Okay, so you’re gonna bet $100 For the chance of winning $500 Okay, sounds interesting? Yes.

Okay. You play along at home. So is that interesting? Okay, now let’s add a little bit more. You have a 60% chance of losing $100 and a 40% chance of winning $500 Okay, are you still interested?

I am because you know, I like to bet so, yeah. Okay, cool.

You know, the numbers, you can play with the numbers, but this is the idea here is there is a formula now when you can… place it; do a bet like that… where you know the odds. I mean, it’s clear like the 60 and the 40 Right.

Okay, you can calculate the expected gain or loss of that transaction. It’s a real simple formula. You multiply the 60% (.6) times 100. And that’s a loss of $60 and the .4 times the 500, and that’s $200. And so 200 minus 60 is $140. So this has a positive expectation of $140.

Now, it’s still a bet. So you know, you’d have to do it 100 times. But over 100 times, you can expect that on average, you’re gonna make $140 on you know, over some period, you know, the over the transaction.

I could be a little off on, you know, how the total was tiny, but that is, it’s a positive expectation game, you should play that. You should take that bet. Yes, without hesitation.

But if so, the point was we framed it by mentioning the loss first. Right? You’ve had a 60% chance; that’s more than 50-50 on the coin toss of losing $100 That tends to trigger the loss aversion bias and most people… it did some in you then you hesitated. You had to think about okay, it didn’t seem like as good a deal right? Okay.

All right, perfect, not as good as 40%. And the thing is, now let’s go to the stock market, because we talked you mentioned trading, stock markets a whole different deal because you cannot calculate accurately those percentages, you know, my probability of winning or loss and how much and now, you know, little, but here’s what, typically we can still play the game and here’s what typically happens.

So, you buy a stock for $100. Okay, and it goes up to $130. You’re a genius, right? And then it drops. It drops by $10 Okay, so now it’s $130 and then it goes up. Sorry. $120. Then it goes up. $5 back to 125. Cool. Yeah. Well, then it drops down $10 Right now it’s what 115 Right. And it keeps doing that up and down, up and down. But every time it drops $10 in the only goes back up five, and eventually it’s at $70. Okay, now you started at 100 Right? It went to 130. So you get a gain of $30. Right now you got a loss of $30. Okay, what do you do?

At that point, I would probably hold it and see what happens.

And that’s exactly what most people do. They didn’t take the win, right? And then they’ve seen that now they have a loss. They don’t want to “realize”, or take, the loss by selling the stock, even though they’re now at a point where they’ve, you know, it’s the loss is greater than the potential gain at this point.

It’s gone to 130 and fallen away $60 The likelihood of it now turning around and going back above 130 on that time is small, but but that’s we don’t want to take the loss and so what happens in the stock market with a lot of investors is that you know, emotional attachment to you know, I did this and I, you know, went up, it went up to 130. And so they hold on to that hope that it’s going to go back and they will write it and eventually, you know, and then it’s it gets down to $40 and then and then it’s like well, I might as well hold on to it now and you know and then it goes to you know, $10 in stays there for 10 years, and it’s just some money that they couldn’t could have used somewhere else.

So there’s some you know, there’s like your profits when you This is another effect. I can’t give you stock advice. Not licensed, but the the loss aversion bias is at work there. Were it’s a different form of it. Right? It’s but it’s not wanting to accept that loss. Yeah, that takes me off.

Okay, now, how does so how does this loss aversion bias get used against us? Okay, when I say against us, we all have it. So it’s it’s really, you know, it’s just taking advantage of our natural tendency the way we think it’s not it’s not a personal attack. Okay. That’s cool.

Okay, so think in terms of something going on sale. I’m trying to stay in the frame here. Sale, something going on sale, right. And it’s only on sale for this week only. Right? Okay, so now you’ve got you’ve got a reduced price. It’s good for this week only. What is that? How do you feel about missing out on my phone on that sale on my phone right? That’s crazy. Okay, so whatever amount it’s on sale for that’s we perceive that as a loss if we don’t capture it by by buying that thing if it’s something we want, right?

If it’s something we don’t want you know like if it was you know, me and a pink tutu went on sale for, you know, half price, I might look good, but I’m not interested in buying it and so that sale isn’t going to affect me and I’m gonna have no sense of of loss about it.

Okay, but, but it is that’s the principle at work and know the idea that it’s going to this this reduced price this bonus, this value is going to get away from us.

Does it make any difference with the percentage?

I wouldn’t think it does. And this bias affects us all individually based on our past and our past experiences, especially in terms of the you know, like the stock market thing.

I can again speak to that. If we’ve taken a big loss, that loss aversion bias is then gets accentuated and it can affect many, many future transactions, not only in terms Yes, it did. Not only in terms of you know, once we’re in a position, you know how we manage it, but even our willingness to take a risk. Oh, yeah, no, we’re once we’ve been burned or hurt.

And that’s how we see we perceive it personally think that loss especially if the loss is bigger than we expected it to be. Then then that the memory of that pain makes us much less likely to take additional risk, even smaller risks later on. Okay, okay.

Another another interesting fact about this. This this fear gets triggered even stronger when there’s cash than with credit card okay. So Cash is immediate, whereas credit card data you’re looking at anywhere from…

Oh my god, you’re nailing everything today! Yes, it is!

I mean, from a day to a month out, right?

It’s that immediate gratification or the immediacy of the… cash is real money right now. And if I pay if I pay cash for this, it’s gone. Right? Whereas when I put it on a credit card, that’s a month away.

Almost, and that’s the next thing.  If you’re a marketer, you want to make it easy for people to pay with a credit card; really easy. Because they pay almost 100% more for something with a credit card than…

You don’t want to again, you don’t want to look at your wallet, see it empty.

There’s less… yes, there’s just less fear about that. The other thing is, if you ever done one of those been involved with a company where they you, you accumulate points somehow like you’ve got a membership and every month, you they give you 100 points towards, you know, that you can spend towards their products, right.

Well think about that. We talked about cash versus credit cards. Now think about those points versus cash right? You’ll spend those points like they’re nothing right right you I mean they so they can so they will automatically charge more for something if you’re going to pay by points than cash, think of mileage buying airline tickets with miles. Yeah, I want miles

I found that out as much as I love them… Yeah.

So. Okay, so how do we avoid how do we avoid this? How do we avoid getting getting overly influenced by this loss aversion? Okay. Well, first thing is slow down. Okay. You’ve got to notice what you’re feeling. One of the ways that we get caught up in both sides of this is by getting excited, you know, emotion gets, and we act on emotion.

This is because I’m sorry, we’re not rational and we make 98% of our decisions with our fast thinking system or are just impulsive. You know, it’s, we’re on autopilot 98% of the time, and our autopilot system works with these biases automatically.

So you’ve got to slow down. You got to pump the brakes just a second. Notice what you’re feeling then.

You want to reframe the transaction in terms of the gain, the potential gain, rather than thinking about the loss. So what am I going to get? And then what’s the risk versus… Okay, what am I risking and then and then try to weigh the gain against that because you’re always gonna put yourself it’s the way we’re wired, we’re hardwired to survive to protect ourselves.

So you got to turn it, turn it around, look at it from the other side. Okay, so think of a gamble in terms of framing it like that. Thinking about I’m going to buy a coffeemaker. Okay. And I’m going to buy a coffeemaker from you know, one of the companies like what’s the Keurig or Nespresso? Yeah, I mean, that’s, that’s a well-known international company, they stand behind their product right?

So if I’m going to spend a couple hundred bucks, it’s an uncomfortable amount because it’s a high end product. They’ve got higher ones, but I also know that IF there’s something wrong with it, they’re gonna probably honor the warranty versus you know, buying it off the back of a truck from a guy never saw before.

Okay, now what about the other thing? A lottery ticket? Yeah, versus the coffee machine. I’m paying a couple 100 bucks. I know I’m getting something. It didn’t cost them 200 bucks to make. But, you know, I’m getting some relatively close value. I’m trying to buy something that’s worth more than I’m paying for it. Worth more to me than what I’m paying for.

Okay, now look at a lottery ticket. What’s the expectation with a lottery ticket?

No win.

Yeah. And you’ve got more chance to get struck by lightning trail than you do of winning the lottery. I love so we live in Florida.

So that’s another this is a judgment. That you can use as you know, if there’s an element of this of a windfall of some kind, you know, out really large when compared to what you’re paying. You’re probably… it’s probably not a good deal. And you’re and this is where your loss aversion should come into play.

And we’ve had a couple of family members… have their lottery ticket as their retirement.

These are the ones these are the ones you want to run away from and that’s where your loss aversion should be helping you.

The other side of… taking the other side, looking at it as “Okay, if I was instead of I’m buying this, if I was going to sell this if I was on the other side of this deal, would I? What would I want to be paid in order to give what I’m giving?”

Probably a whole lot more than what… and so that tends to balance things out and that’s where you would, you know, you could bring that loss aversion back into back into balance.

So it really is about just engaging that slower thinking system, thinking a little more carefully rather than reacting emotionally. That’s the bottom line.

That’s the loss aversion cognitive bias and how it shows up. Well, how it shows up in our lives every day. We are hardwired, we can’t avoid these things completely, because they’re part of us and they helped us survive at some point. But now we’ve got to know how to manage them the best we can.

Okay, so thanks so much for spending a couple minutes with us. And we will see you soon. Bye.

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