pen rainbow

Sunday, January 11, 2015

Sunday—Have a Risky Week!

Why taking reasonable risks will always lead to success

Lucky Streak lounge sign at McCarran Airport_photo by dsmp

Playing It Safe v. Risk-Taking 

I am a fan of playing the odds.  I am a bigger fan of certainty, especially when it comes to money.  So, when I watched this video by Veritasium hosted by Derek Muller, I was intrigued by the notion that risk-taking leads to success.

For the record, this is not about gambling.  As a native Southern Nevadan, I'd just like to remind everyone that the odds are always stacked in favor of the house, so keep that in mind the next time you step up to a slot machine.  Successful gamblers quit playing when they win.  Inexperienced tourists don't, and they will always lose if they keep playing because the odds are in favor of the casino.

That said, the Veritasium video explores the nature of risk and how we respond to it even when the odds are stacked in our favor.  Given the opportunity to take a relatively safe risk, most people will pass on that opportunity for fear of losing what they already have.


Let's look at the even bet,  a 50/50 chance of winning or losing.  It's a coin toss, and Derek starts with a $10 bet.  It's a $10 gain if they win, and a $10 loss if they lose.  An even bet has zero expected value because the value of the gain is the same as the value of the loss.

I would take a bet like this because I don't mind losing $10 if I have an even shot at winning $10.  Fun!

Okay, so what if the value of the win is higher than the value of the loss?  Would you be willing to give up $10 if you had a chance to win $20?  The risk just got safer because the chances of doubling your money are the same as losing only half of that amount.  The expected value of this bet is $5 because $20 minus $10 = $10 divided by half (chances are 50/50 that you'll win or lose) = $5.   It's a safer bet with a higher gain, but most people will not gamble on losing what they have.

Why not??  Psychologically speaking, people place a lot more value on loss than they do on gain.  The feeling of loss is a more intense negative experience than the positive feelings associated with gain.  The natural human tendency to avoid experiences that make us feel bad is called, loss aversion.   How averse we are depends on the individual.  Does this mean that people with stronger constitutions are more willing to take risks?  Probably.  Are emotionally-sensitive people less likely to take risks throughout their lives?  Probably.

What does it take to overcome loss aversion?

  • A bigger payoff.  People who were unwilling to take Derek's bet even when the odds were in their favor changed their minds when the amount of the prize increased.  A $10 loss and the possibility of winning $50 rather than $20 was an acceptable risk. 
  • A sure thing.  In Derek's experiment, the same bet was repeated enough times to guarantee a win.  A coin tossed 100 times will result in a win 45 to 55 times.  The expected value of the 100-coin toss bet now becomes +$500!  

If the coin is tossed 100 times...

50 coin tosses X $20 = +$1,000
50 coin tosses X —$10 (minus because you will lose $10 for each time the coin does not come up in your favor) = —$500

Even with a guarantee of certain losses, this bet is a sure win.

Risk-Takers & Experience

What this experiment shows is that loss-aversive people are likely to miss favorable opportunities to add value to their lives.  We are naturally cautious creatures, and risk-taking does open us up to experience more loss, but successful risk-taking amounts to a greater gain over time, in terms of quality of life and personal accomplishment.  In a business context, smart risk-taking is part of an overall strategy for financial success.

What the Veritasium video illustrates so beautifully is that people who are willing to take risks are also more likely to experience spontaneous moments of delight and surprise when the risks pay off.

That adds up to an expected value of friendship and a joie de vivre.