If human beings are naturally risk-averse, then what the heck happened on Wall Street?
For roughly two decades, the new science of behavioral economics has been challenging what economists call “rational choice theory.” Rational choice theory described that primate species called Homo economicus—Economic Man—as rational, profit-maximizing, and efficient in making choices. When faced with a decision, the theory held, we carefully consider the value of an outcome and make a rational decision about the most efficient course to take to maximize the utility, or profit, of that outcome.
But research in behavioral economics has revealed that many, if not most, of our economic choices are driven not by rational calculations but by deep and unconscious emotions that evolved over the eons. Among these irrational emotions is “risk aversion,” a psychological effect that is actually part of the reason that financial markets work so well. People are more averse to risk than traditional economics would dictate, and that restraint helps keep most speculative market behavior in check.
As everyone knows by now, many of our major financial institutions weren’t nearly averse enough to risk over the last decade and a half. In seeking quick and carefree profits, along with trying to appease politicians pushing for wider homeownership, they tossed all restraint out the window, with devastating economic consequences. How did this happen, and how can we keep it from happening again?
Imagine that I give you $100 and a choice between (A) a guaranteed gain of $50 and (B) a coin flip, in which heads gets you another $100 and tails gets you nothing. Do you want A or B? Now imagine that I give you $200 and a choice between (A) a guaranteed loss of $50 and (B) a coin flip, in which heads loses you $100 and tails loses you nothing. Do you want A or B? The final outcome for A in each scenario is the same (winding up with $150); so is the final outcome for B (an even chance of winding up with $100 or $200). So rationally, whether you are in the first scenario or the second, you should make the same decision, which is what rational choice theory predicts.
But behavioral economists have discovered that most people choose A in the first scenario (a sure gain of $50) and B in the second (avoiding a sure loss of $50). Even though there is no rational difference between having $100 and a sure gain of $50, and having $200 and a sure loss of $50, there is an emotional difference. That emotion is risk aversion, and thousands of experiments have demonstrated precisely how averse to risk we are: on average, most people will reject the prospect of a 50/50 probability of gaining or losing money unless the amount to be gained is at least double the amount to be lost. Losses, it turns out, hurt twice as much as gains feel good, and it is our emotions—not our reason—driving our risk-taking decisions. All other things being equal, only when the potential payoff is more than double the potential loss will most of us take the investment gamble.
Read the entire article on the City Journal website (new window will open).