In possibly the best argument for diversification in history, the video below demonstrates how fear of loss can prevent investors from making money, and prevent people in general from benefiting from what life has to offer.
Would you take this bet? In the video, science blogger Veritasium offers people a chance to win $10 on a 50/50 coin toss. Most people don’t accept the bet.
Since anyone who takes the bet has an equal chance of winning $10 or losing $10, the bet has a value of $0.
Next the blogger offers to put up $12 of his money against $10 of his opponent’s money. Then $15. Even when he offers $20 against his opponents’ $10, people still refuse the bet.
Objectively, Veritasium explains that the bet is in the opponent’s favor. A 50% chance of losing $10 and a 50% chance of winning $20 should have a $5 value. As one potential opponent puts it, she thinks more about what she might lose than what she might win. The risk here hasn’t been diversified.
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Losses Hurt More Than Gains
The blogger’s point is that we feel losses a lot more sharply than we feel gains. Most people will attach a psychological value to a loss of about double the value they’ll attach to a gain. The multiplier varies deeply from one person to another. For instance, when the blogger offers $30 against an opponent’s $10, his opponent still refuses, and says even if he offered $50 she would still decline the bet. Other opponents say they would take the bet at $50 or $100 of the blogger’s money put up against $10 of their own.
The scientific name for the principle demonstrated in the video is loss aversion. People will pass up even those bets that are very favorable, like a 50/50 chance of losing $10 or gaining $30.
Many Chances Reduce Loss Potential
The blogger poses the question: What if people were given a chance to repeat the bet three times, or ten or a hundred? In that case, some of the people he approaches say they would take the bet. The rational reason behind the bet’s increased attractiveness when it’s repeated multiple times is this: A single coin toss has a 50/50 chance of coming up either heads or tails, but the outcome will be one or the other. In other words, the bettor will either win the money or lose the money. However, with ten tries or 100, the law of averages comes into play. Given enough tries, there will be an even number of heads tosses and an even number of tails tosses.
Over the course of 100 coin tosses, the bettor will lose $10 about 50 times, but win $20 50 times. Their net outcome will be a gain of about $500. There’s only a chance of one in 2,300 of losing any amount of money at all.
The blogger asks the question, how is it that a rational person will gladly accept 100 of these bets when they refuse to accept even one?
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Risk Diversified Avoids Loss
The blogger concludes the experiment by saying it’s not about gambling. It’s not an attempt to get people to go to a Casino, where the odds are overwhelmingly in the Casino’s favor. Rather, it’s a metaphor for the many risks and opportunities people face each way. Looking at each little risk as an isolated event will most often cause people to say no even to very good risks, because the chance of loss creates too much fear.
If people see each tiny bet instead as part of a long series of bets, it becomes apparent that people who take more small risks in life come out ahead overall.
The video finishes with a montage of Veritasium losing small amounts of money to the video’s participants. As he tells one bettor, the video itself is a risk for him because he’s given away a lot of time and spent a lot of money on it and the video will only make money if half a million people watch it.
It looks like Veritasium’s little bet paid off. To date the video has over 1.5 million views. Score one for taking chances.