We all make decisions all the time. And we are very rational. Are we not? We make rational decisions. This is called utility maximisation by economists. Economics is not called the dismal science for nothing you know.
This is how we make decisions: we look at all our options and we decide the relative likelihood of each actually occurring. Then we look at the value each option gives to us. We then synthesise this information and we make our choice. This is rational decision making.
However, what I have described is how a computer algorithm might make a decision. But we are not so clever. Or should I say not so rational.
We especially do not make decisions like a computer when there is a gain or a loss involved.
Two economists, Kahneman and Tversky won the Nobel Prize in 2002 for their work on what they called Prospect Theory, which describes decisions between alternatives where there is a risk involved.
Their studies showed that people are much more sensitive to a loss than to a gain. This is true to such an extent that people are willing to take on board serious risk to avoid a loss. For example, people sell shares when the stock market goes down, and they continue to pour money into something that they have put money into previously when they really should just walk away.
It was Warren Buffet who said that “losses gain twice the emotional response of gains.”
People are risk-averse (i.e. they play it safe) in relation to gains, but are also loss-averse (and will gamble to avoid losses).
Makes no sense at all.
Here’s an experiment – people were asked to imagine they were scientists and they were working on an outbreak of a nasty disease which was expected to kill 600 people. Two different programmes to fight the disease have been proposed. The first group of people were asked to decide between these two programmes –
A: 200 people will be saved.
B: there is a one third probability that 600 will be saved, and a two-thirds probability that no people will be saved.
In this case, 72% of the group favoured programme A.
A second group of people were asked to decide between these two programmes –
C: 400 people will die.
D: there is a one third probability that nobody will die, and a two thirds probability that 600 people will die.
Now you will see that A is the same as C and B is the same as D. It’s just that the first choice (A or B) is framed as a choice between gains and the second choice (C or D) is framed as a choice between losses.
In the second case, 78% of people preferred programme D. Their preference has been reversed by changing the frame from gain to loss, although the options are essentially identical. Hmmm…
So, why care about this?
Well, marketers have us sussed and they use this to their advantage.
Would you rather get a 10% discount or avoid a 10% surcharge? It’s the latter, because loss-avoidance trumps a gain. Hence the often used phrase “sign-up by the 17th or you will lose…”, or “offer ends Sunday…”
Prospect theory explains both why we act when we shouldn’t (usually to avoid loss, i.e. in selling shares when the market goes down) and why we don’t act when we should. In fact, the more choices people have the more likely they are to do nothing. And the more good or attractive options there are, the worse the paralysis. And the longer the decision is deferred, the less likely it is that a decision will ever be made.
For example – one study asked people to complete a questionnaire for a decent reward: some were told the deadline was 5 days, others 21 days and a third group had no deadline. Results: 66% returned within the 5 day deadline, 40% in the 21 day deadline and 25% where there was no time limit. And it wasn’t because they forgot.
So if you find yourself with decision paralysis, consider this –
- Not to decide is itself a decision. Procrastination must be killed!
- Think of opportunity cost, i.e. doing nothing may be more costly than doing something sub-optimal.
- Play devil’s advocate – challenge assumptions and consider the issue from scratch, not where you are today because what’s already invested is a sunk cost. You cannot get it back no matter how much more love and money you throw at it.