Mediation and the Science of Decision Making Part III: People Avoid Risk When They Stand to Gain and Seek Risk When They Stand to Lose

In my last post, I said that Kahneman and Tversky revolutionized economics by showing that people do not act rationally when making economic decisions. As I explained, classical economic theory predicts that people will analyze risk rationally, regardless of the circumstances.  As it turns out, people don't do this. Instead, they try to avoid risk when they stand to gain, but they seek risk when they stand to lose. 

Try this mental exercise, and you'll see what I mean.  

Which would you choose? (A) a sure gain of $750 or (B) an 80% chance of winning $1,000 and a 20% chance of winning nothing?

The rational choice theory predicts that people will choose Option B, which has the higher expected value. The expected value of an 80% chance of winning $1,000 is $800. That obviously is greater than the value of the $750 sure thing. Any rational person seeking to maximize his financial gain should choose Option B.

But if you are like most people, you chose Option A and you didn't even have to think about it. Your automatic reaction was that you would rather have the sure thing than take the gamble. If you did the math, you likely noticed that the gamble offered only an incremental gain over the sure thing, but it also left you with the possibility of getting nothing. You likely saw this and figured, “Why risk it?”

Now try this one. Which would you choose? (C) a sure loss of $750 or (D) an 80% chance of losing $1,000 and a 20% chance of losing nothing?

Here, the rational actor theory predicts that people will take the sure thing, which is more likely to minimize financial loss.  The gamble here, Option D, has an expected value of negative $800, versus the sure thing’s value of negative $750. Taking the risk here is the worse choice, rationally speaking.

But again, if you are like most people, you chose Option D, and again, you didn't even have to think about it. You had an instant and very negative reaction to the idea of losing $750. The thought actually caused a number of physical stress reactions that you probably did not notice: your pupils dilated, your heart rate increased, the hair on your arms rose slightly, and your sweat glands were activated. The gamble offered you the possibility, even if small, of owing nothing, and thinking about this possibility reduced your stress level. You decided to take your chances on the gamble, even if you realized that it was the worse option, rationally speaking.  

Put these two mental exercises together, and you see what Kahneman and Tversky found: when people stand to gain, they prefer to avoid risk; but when they stand to lose, they prefer to take risks.

If you go back to the examples that I gave in my first post, you can see that this risk-avoiding and risk-seeking behavior helps explain why Adam and Company C fail to take advantage of reasonable settlement opportunities. They have no option that leads to gain – or a sufficiently substantial gain in Adam’s case – and they choose to take the risk instead by taking their cases to trial. They do this even though they recognize that the odds of winning at trial are small, and the likelihood is that they will do worse than in a settlement.

This also helps why Denise takes a relatively low settlement offer when she likely could do better. Being in a position of likely gain, she seeks the certainty of the settlement, rather than risk everything at trial.  

Next week: Reference Points.