The Little Book of Behavioral Investing: How not to be your own worst enemy

Chapter Fifteen

You Gotta Know When to Fold Them

When it’s Time to Sell an Investment

 

 

 

 

 

 

TIME FOR ANOTHER GAME—IF YOU DARE.

This time, let’s toss a fair coin. If you loose you must pay me $100.

What is the minimum amount that you would need to win to make that bet attractive?

Let’s assume you can only deal in one dollar units. The rational response is therefore an answer above $100. In fact, if you are risk neutral you should be willing to play for $100. However, when I ask this question I generally get a much, much higher response than $100. In fact, the average response from the 600 fund managers who have taken my test is just over $200. That is, they need to win twice the amount they may lose before they will consider this a good bet.

This result is typical for such a question. In general people hate losses somewhere between two and two -and-a half times as much as they enjoy equivalent gains. This is a property known as loss aversion.

In my sample of fund managers we got the full range of responses from those who required $1000 or more (over ten times as much as they stood to lose) to those who would have accepted just $50. I guess the former thought I was pathologically incapable of using a fair coin, the latter simply loved giving money away.

In general, people’s performance on the cognitive reflection task (CRT) from the introduction of this book is reasonably correlated with the degree of loss aversion they display. For instance, those who got only one of the CRT questions ...