I like to gamble. Actually, that’s a lie. I love to gamble. Poker and craps, mostly, but if I’m bored enough, I will literally gamble on anything. I’m fortunate in that I’ve developed a bit of skill at the games I normally play, and in that I’m the luckiest person you will ever meet. One more thing makes me a good gambler: I understand human psychology. Here are two innate human characteristics you must understand if you want to avoid big losses, in gambling, or in life.
Pretend you bought a share of Apple. Now pretend you’re staring at the stock ticker. It would seem logical that the intensity of the happiness you would experience if the price goes up $1 would be the same as the intensity of the sadness you’d experience if your stock went down $1. Turns out, it’s not even close. Depending on the study, researches have found that people experience the intensity of a loss between 2.5 and 7 times greater than they experience the intensity of a gain of the same amount.
This universal human characteristic is known as loss aversion, and the fundamental irrationality that drives it not only affects how we feel about gains or losses that have already happened, but powerfully guide us to make decisions that appear to avoid future losses. If you’ve ever bought a flat-rate plan or the full coverage rental insurance, you’ve experienced this first hand. At one time, cell phone companies charged by the minute, but they soon began offering more expensive flat-rate, unlimited calling plans. People signed up in droves, most of whom would never have hit the number of minutes where the flat-rate’s price would have made sense, because of the fear of running over their plan’s allotted minutes and being charged penalty rates. Similarly, car rental companies have suckered people into buying insurance that’s redundant two or three times over (since your credit card and regular car insurance generally cover rental damage/loss) by offering to sell you a “loss damage waiver.” That’s the power the word loss alone elicits in us.
Loss aversion in itself isn’t horrible. Humans exist today because of it. It’s far safer to be weary of every rustle in the grass, always prepared for the poisonous snake, than it is to assume its not a snake based on the overwhelming probabilities. But, when loss aversion combines with other irrational behavior, it can become very dangerous. For instance, the more meaningful a loss is, the more loss averse we become. When more is at stake, we risk making decisions that become progressively less rational. Investors and investment advisors are so familiar with this type of irrationality they have their own phrase for it: chasing a loss. The worst part about loss chasing is that often times you’re not chasing a loss at all. If you bought your stock at $50, watched it go to $100, thought about selling but didn’t, then watched the stock slide down to $90, you could still sell now for a $40 gain. But many people refuse to sell, reframing the $40 gain as a $10 loss. In these circumstances, merely recognizing that loss aversion exists can impart some rationality, saving you a lot of heartache when the stock drops to $0.
Normally we think of commitment as a positive attribute, but in the world of rational behavior, it can combine with other irrational behaviors to produce devastating results. Once people become committed to behaviors, practices, or positions, it becomes increasingly difficult to break free from them, even when they clearly aren’t working anymore. The more people invest in something, be it time, money or energy, the more they feel like they need to continue that thing, lest all their prior effort be for naught. When commitment is combined with loss aversion, we end up with results of the $1 auction.
The way this usually works, around the $.50 mark, the bidders realize what they are in for. Yet still, rather than just cutting their losses and conceding the $.50, they dig in and commit to decisions to attempt not to lose. Here, loss aversion combines with commitment to fuel behavior that, from the outside, seems outrageously irrational. Who would pay more than $1 for a $1 bill? Well, if you’re losing bid is $.50, you might as well bid up to $1.50, since you’d be losing the same $.50. And of course this thinking continues. There are different versions of this game, but the outcome is always the same. In a legendary version conducted at Harvard Business School where only the second highest bidder had to pay, the “winner” ended up paying $204 for a $20 bill. Ouch.
Two more epic examples where loss aversion and commitment combined to horrific effect were the Vietnam War and GWB’s Iraq/Afghan wars. In both instances, LBJ and GWB jumped into a situation that looked easy to win. Each looked like chance to buy a $20 bill for $2. But, as other unforeseen factors intervened, as stakes grew, both men became committed to not losing. As Daniel Kahneman, the Nobel Prize winning economist who first described loss aversion, said, “To withdraw now is to accept a sure loss, and that option is deeply unattractive. The option of hanging on will therefore be relatively attractive, even if the chances of success are small and the cost of delaying failure is high.”
This is a profound insight into how human beings operate. We’d rather hang on, even though the longer we do so the worse the probabilities for success become, than to accept a small loss today. This realization can be crucial, not only to a gambler, but also to anyone in a negotiation, especially one where the stakes are high and the timeline is dragged out. As people invest more in their positions, they become more committed to them, even if they are ultimately detrimental. LBJ refused to withdraw from Vietnam early because it would have cost him valuable political capital he wanted to expend building his “Great Society”. In the end he lost a war, thousands of American lives, and any opportunity to achieve his ultimate goal.
The Gambler was right: you need to know when fold ‘em, and when to walk away. (On the other hand, don’t ever run away from a table though, that’s horrible advice: you’ll end up getting either shot or arrested.) It’s ok to lose. The key is to make sure those loses don’t spiral out of control.