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Thinking, Fast and Slow, Part IV – “Losing feels worse….”

Beginning last week, Morning Feature has been looking at Daniel Kahneman’s book Thinking, Fast and Slow. Last Thursday we saw the two ways we think, fast and slow. Last Friday we examined our mental shortcuts and biases. Last Saturday we explored overconfidence. Today we’ll consider how we make weigh choices and chances. Tomorrow we’ll meet our two selves, experience and memory. Saturday we’ll conclude with how our improving model of human thinking should shape public policy.

Daniel Kahneman is a Professor Emeritus of psychology and public affairs at Princeton University’s Woodrow Wilson School of Public and International Affairs. In collaboration with Amos Tversky, Dr. Kahneman was a pioneer in the psychology of judgment, decision theory, and behavioral economics. He was awarded the 2002 Nobel Prize in Economics for his work in prospect theory, and has taught at universities in Israel and across the U.S.

What is “Rational?”

We met Humans and Econs back in September during our discussion of Richard Thaler and Cass Sunstein’s book Nudge. An Econ, that rare specimen also known as Homo economicus or the rational economic actor, would find it easy to solve the following problems:

What is the most you would pay for:
(1) a 5% chance vs. a 0% chance to gain $100?
(2) a 0% chance vs. a 5% chance to lose $100?
(3) a 10% chance vs. a 5% chance to gain $100?
(4) a 55% chance vs. a 50% chance to gain $100?
(5) a 100% chance vs. a 95% chance to gain $100?
(6) a 95% chance vs. a 100% chance to lose $100?

When economists speak of rational actors making rational decisions – how Econs think – rationality is defined by expected value: the mathematics of risk and reward. In fact, an Econ would question the plural word “problems,” as in Econ-speak that is six variations of the same problem: “What is the break-even cost for a 5% greater chance at $100?” It’s a simple case of multiplying the probability by the payoff, and the answer is 5% of $100 or $5.

But Humans do see those as different problems. For Humans making intuitive decisions, the break-even point varies depending on whether we stand to gain or lose, and whether our chances shift from “none” to “some” or “some” to “certain.” When it comes to questions of chance, Humans are, in Dan Ariely’s title, Predictably Irrational.

Winning and Losing

Sportscaster Vin Scully is credited with the quote “Losing feels worse than winning feels good.” Many athletes and coaches have agreed, and loss aversion is not limited to sports. Dr. Kahneman quotes psychologist Paul Rozin’s observation on the emotional response of disgust: “A single cockroach will completely wreck the appeal of a bowl of cherries, but a cherry will do nothing at all for a bowl of cockroaches.”

Indeed it’s not even limited to humans. Observations of animals show the same pattern of negativity bias, and for good reason. If you sit comfortably in your favorite chair, enjoying a delicious cup of coffee and perfectly cooked eggs while the building is on fire, you are unlikely to survive. Pleasant events are nice, but threats can kill us. However much we may wish the media would offer us more good news, we are hardwired to pay more attention to threats, disasters, and conflicts. If the warnings are accurate and reasonable, a news outlet that emphasizes warnings over celebrations is offering not only what we want, but also what we need … because “Losing feels worse than winning feels good.”

Psychologists have studied loss aversion in a wide range of human activities. Most professional golfers par most holes, so making a birdie putt will usually gain a stroke relative to the field while missing a par putt will usually lose a stroke relative to the field. A statistical analysis of millions of putts by professional golfers found they are 3.6% more likely to make par-saving putts than birdie putts of equal difficulty. The golfers concentrated more intensely on par-saving putts … because “Losing feels worse than winning feels good.”

“That’s mine!”

A child may smile and even say “Thank you!” when given a toy or a treat. But if you take away that toy or treat, the child’s cry of “That’s mine!” will probably be much louder and more intense. Once we have something, we want to keep it: a phenomenon known as the endowment effect. We see that effect in a wide range of political, business, and social interactions. Most Americans are used to energy-intensive conveniences, such as having hot water at any time of day or night, and driving our own cars rather than using public transportation. Energy conservation might save us money – and help protect our environment – but many of us still resist giving up those conveniences … because “Losing feels worse than winning feels good.”

That pattern also plays out in negotiations. We tend to discount the other party’s concessions relative to our own, because our concessions involve giving up something we already have or expect to have, and negotiations to divide gains (how to slice a bigger pie) are far easier to resolve than negotiations to divide new losses (how to slice a smaller pie). Viewed from the outside, each party in a negotiation will usually demand more than they offer in return. But each party will believe they are negotiating fairly … because “Losing feels worse than winning feels good.”

We also see the endowment effect at work in reform efforts. Whether government or business or a family, changing the rules will create winners and losers. If the reform is worthwhile, the wins are greater than the losses, in numbers of people and/or the significance of the benefits and losses. But the would-be losers will weigh their losses more heavily than the would-be winners weigh their potential benefits. The would-be losers will usually work harder to block the reform than the would-be winners will work to enact it, and most reform efforts fail or are at best incomplete … because “Losing feels worse than winning feels good.”

Possibility, probability, and certainty

Dr. Kahneman and Amos Tversky developed the idea that “Losing feels worse than winning feels good” into a mathematical model known as prospect theory, for which Dr. Kahneman won the 2002 Nobel Prize in Economics. (Dr. Tversky died in 1998, and the Nobel Committee do not award posthumous prizes.)

Among their most interesting findings was how we weigh changes in probability along the scale from “impossible” to “certain.” Look again at the six problems I offered above, and focus on the first two and last two. Dr. Kahneman found that we overvalue very small probabilities such as a 5% chance vs. 0% chance, and undervalue very large probabilities such as a 95% chance vs. 100% chance. In mathematical terms, those are no different from a 5% chance vs. a 10% chance, or a 50% chance vs. a 55% chance. Econs see each as a 5% change in probability.

But Humans see them very differently: as qualitative changes from “impossible” (0%) to “possible” (5%) and from “very likely” (95%) to “certain” (100%). At the low end we intuitively apply what Dr. Kahneman calls the possibility effect, where even a tiny chance to gain feels much better (and a tiny chance to lose feels much worse) than an impossibility. At the high end we intuitively apply the certainty effect, where a very likely win feels less attractive (and a very likely loss feels more attractive) than a certainty. Dr. Kahneman combined loss aversion and our intuitive assessment of probabilities in this table:

FourfoldPattern

* In the upper left corner we see a very likely vs. certain gain: we fear disappointment, avoid risk, and often accept an unfavorable payoff because “I’d rather get something than nothing” (e.g.: structured settlements).

* In the upper right corner we have a very likely vs. certain loss: we hope to avoid the loss, accept risk, and often reject a favorable payoff or commit too few resources because “it might not happen” (e.g.: climate change).

* In the lower left corner we see a small chance to win vs. no chance at all: we hope for the big gain and accept risks because “you can’t win if you don’t play” (e.g.: buying lottery tickets).

* In the lower right corner we see a small chance to lose vs. no chance at all: we fear the big loss and avoid risks even at extreme cost because “we can’t take a chance” (e.g.: response to terrorism).

Those responses aren’t rational to Econs, but they’re very predictable among Humans. You might think we’d learn better, but tomorrow we’ll see why that’s harder than you’d think.

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Happy Thursday!