How to Master the Psychology of Judgement in Investing

April 22, 2024

Imagine walking down the street and a sign catches your eyes “Win $1,000!”  Intrigued, you approach the gamesman, and he offers you a choice.  He will either give you $500 and you can go on your way, or you can flip a coin, heads - you win $1,000 or tails - you win nothing.  What would you choose?

Now, suppose you just had your car repaired and the mechanic says, “the bill is $500, but we have a new promotional game.”  He then offers you the option of paying the $500 bill or you can flip a coin, heads - you will own nothing or tales – now you owe $1,000.  What would you choose?

You are probably inclined to take the guarantee in one situation and flip the coin in the other.  In a similar study, researchers found that 80% chose the guarantee in the first scenario but only 30% chose the guarantee in the second.  Why is there such a difference in our appetite to gamble? We can look to the work done by Daniel Kahneman, who passed away about a month ago. 

Kahneman's Influence on Behavioral Economics

Daniel Kahneman is best known for his work on behavior and the psychology of judgement in decision making.  Kahneman and his colleague Amos Tversky’s research laid the foundation of behavioral economics/finance.  Their research demonstrated people often make mental errors and have cognitive biases, this was contrary to most classical economic models at the time, which were based on a “rational being” to explain people’s economic decisions.  

In each of the examples above, the guarantee and the coin flip have the same probabilistic outcome.  A rational being would be indifferent between the two as they have the same expected payout $500.  Either you take the $500 or you have a 50% chance of winning $0 or a 50% chance of winning $1,000.  But, when we are presented with options, most of us do not make calculated probabilistic analysis of the situation.  We have a feeling that inclines us to take the guarantee in one scenario and gamble in the other. 

The world of behavior finance continues to expand building on the foundation of Kahneman’s early research.  If you are interested in learning more about this topic, let us know.  We can incorporate a regular blog to unpacking different cognitive biases that many investors face.  Whether we like it or not, emotions play a role in our financial decisions.  Fortunately, we often have the ability to plan ahead, work through the analysis, and make decisions before our emotions peak.  This is why planning and preparation are effective tools for financial success.  If you would like to build a financial plan or review your accounts,reach out to your Financial Advisor today.  Your financial success matters to us.