How losses and gains carry different weights


MOST people are emotionally more averse to losing than they are attracted to winning. This means that most people would not take a 50/50 chance bet in which you can either win RM100 or lose RM100. This is because losing RM100 hurts you more than winning RM100 makes you happy. 


Ask yourself: How much do you need to win in a 50/50 chance bet, where you could lose RM100, in order to accept the bet? Research has indicated that a gain needs to be roughly two times larger than a potential loss. This means someone would only risk losing RM100 in a 50/50 chance bet if he or she had the chance to win RM200. 

For business and household finances, it makes a lot of sense to treat loss of income with greater urgency than potential gains of income. In the long-term, this attitude will protect you better from dire financial situations, than if you would treat losses and gains of income with the same urgency.

At once or spread it out?

This asymmetry also creates an interesting dynamic in how we want to deal with gains and losses. We typically want to take losses at once, in order to ‘get over with it’ and move on. However, we want to spread gains over time in order to remain happy with the gains for as long as possible. 

Let’s say you win a lottery and are entitled to RM1mil. You would become happier if you were paid RM200,000 for the next five years, than if you were paid RM1mil at once (not taking interest into account). 

The reason for that is that your happiness fades over time, even after winning the lottery. By being paid over a five-year stretch, your increased happiness will be reactivated every time you receive the RM200,000.

On the other hand, let’s say you have a personal loan of RM5,000 to pay off. It will emotionally hurt you less if you paid it off in one go (assuming you would be able to do so), than to pay it off in five installments of RM1,000.

Risk-seeking behavior

Interestingly, loss aversion can also make you more open to risk-seeking! 

Consider the following question. What would you choose: 100% certainty that you are losing RM900 or 90% certainty that you are losing RM1,000? 

Although the expected loss in both cases is RM900, if you are like most people, you would go for the latter option. 

In the latter option, you can avoid the certainty of losing money and you have a small chance of not losing anything. People can’t stand the certainty of losing money! 

However, you will most likely lose RM1,000 and be worse off. Because the pain of certainly knowing that you are going to lose RM900 is too much to bear, you become willing to take a big gamble.

How can you use these insights?

You can make yourself less unhappy by paying for things at once instead of installments, to reduce the amount of ‘pain’ you feel about departing with your money. 

Save before buying something, instead of taking out installments. It’s cheaper and hurts less!

You can make other people – say your kids or employees – happier by paying them more often. For example, paying salaries weekly instead of monthly, or giving your kids daily ‘pocket money’ instead of weekly.

Try a cashback credit card instead of an air miles or rewards credit card. The first one gives you an immediate discount and makes you immediately a little bit richer / happier. Air miles and Reward points take a long time to collect before you have something that is worth redeeming.

Be careful you are not becoming reckless when confronted by certain losses. Take the loss and move on, instead of pursuing high-risk gambles in order to prevent the loss. 

In 1995, Barings Bank collapsed after its investment banker Nick Leeson in Singapore lost RM 5.2bil of the bank’s money in very risky speculative investments that he made in order to recover from his previous losses.

Mark Reijman is co-founder and managing director of www.CompareHero.my, dedicated to increasing financial literacy and to help you save time and money by comparing all credit cards, loans and broadband plans in Malaysia.



   

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