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Apr 24, 2002 3:19 pm Psychological Studies of Risk Seeking
Sean Phelan
Interesting column:

PSYCHOLOGICAL STUDIES OF RISK SEEKING

Psychologists have been studying the conditions under which people seek out risk. You may have seen a classic set of questions that has been used by psychologists to study risk:

In which stock would you prefer to invest?
(A) Stock A will produce a sure profit of $250
(B) Stock B has a 25% chance of producing a profit of $1000, but there is a 75% chance the stock will produce no profit.

About 70-80% of the people asked such questions choose option A. They prefer a sure profit of $250, even though there is a chance they can earn four times that amount by purchasing Stock B. In other words, they avoid risk when they think an investment will produce a gain.

People think differently when they consider taking a loss, however. Consider a similar question that is "framed" in terms of losses rather than profits:

In which stock would you prefer to invest?
(A) Stock A will produce a sure loss of $750
(B) Stock B has a 25% chance of losing nothing, but a 75% chance of losing $1000

When asked this question, presented in terms of losses, people tend to choose Option B. When it comes to considering a loss, they are willing to take a chance on preserving their investment. But, they also accept the possibility of losing the entire investment, rather than taking a sure loss. In summary, responses to these questions show that people are risk averse when they believe they are about to make a profit, but risk seeking when they think they are on the verge of taking a loss. This is a seminal finding in investment psychology.

A recent scientific study by Drs. Lerner and Keltner reveals that this traditional understanding of risk and decision-making is not shown by everyone all of the time. One factor that predicts risk aversiveness is the tendency to believe that the outcomes of events, such as future stock prices, are easily predictable, in contrast to viewing outcomes as difficult to predict. In addition to measuring the tendency to view outcomes as easily predictable, Drs. Learner and Keltner asked participants to make choices similar to the ones outlined above.

They found that participants who tended to believe that outcomes are easy to predict tend to seek out risks. They are willing to take a gamble if there is a chance they can make a big win. In contrast, people who tend to believe that outcomes of events are often uncertain and difficult to predict, tend to take the sure thing. They don't like taking chances.

Where do you lie on this continuum? Do you tend to think that one can easily predict the future price of stocks and commodities? Do you have high expectations that prices should move in your favor? Are you often disappointed when price action is not consistent with your expectations? If you tend to agree with these questions, you may tend to seek out and take unnecessary risks. You may want to look out for this tendency. Make sure that when you make an investment, your predictions are based on solid evidence, rather than on your gut instinct. Be aware that you may tend to be a little too sure about your ability to predict events and this will make you want to take unnecessary risks.

Remember the old adage "cut your losses short." It's probably beneficial to show caution and be appropriately risk averse. Take a sure loss, rather than take an unnecessary risk that could result in the loss of your entire investment.

Private Reply to Sean Phelan (new win)





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