Parable of the lost cookie
and Prospect theory

Risk taking and attitude towards losses

The prospect theory shows how investors usually give much
more negative value to a loss than positive value to a gain.
In their mind, a loss can be compensated
only by a twice or three time more sizable gain.

In the same way, they often prefer to keep a losing asset
than to take the money that is left and invest in a worthier one.

sous What gain do you think you need to offset a loss?

Theories on
economic and financial risk-taking
Our attitude towards risk risk is obviously important in human
decisions and behaviors.
A platitude, I know, but it challenges us to understand how this
attitude
guide our actions
It is not just about observing how pedestrians choose where and
when to cross the street.
Crucial, yes, but this article focuses mostly on money-related
cases, as this attitude has obviously important economic and
financial effects
In areas in which money is at stake, more specifically economics and
finance, 
to put in balance expected
risk risks and expected
 boiterewards
has been a  classical topic leading to many studies and
theories.


In this field of research (and in its applications) there are two approaches
by academics and professionals:
(if relevant statistics exist),
  • But some analyze also the "soft part", the risk taking "human side",
This includes the deciders' attitudes and preferences towards
risk and uncertainty. Here attitudes play a key part, as seen
below

The part played by risk attitudes

in those theories

Now that we enter the area of human attitudes towards the expected
economic
risk / reward balance, in other words towards gambles, there
has been three main theories:
  • Risk aversion and risk premium
They were theorized in the 18th century by Bernoulli with his
St Petersburg beggar parable.
The expected utility concept, which defines how an investor
values,in hard cash, a risky asset or venture,  also originates
from those notions.
  • Since then, Maurice Allais formulated his paradox.
It considers that however tiny the probability of loss for a
player, it would incite him, if that loss could bring him a
 
poor total ruin, to avoid to commit his money even to seize
a very high gain opportunity.
  • Still more recently, the prospect theory and the loss aversion.
brought the Nobel prize in economics to Kahneman, one of the
fathers of 
behavioral economics and finance

That last (fascinating) theory - in which a loss that already occurred
has a much stronger influence on decisions than the future risk

- is still not widely known.
Therefore I illustrated it with...my own parable.

The parable: the cookie and the sea

You feel happy on a cruise ship (or on your yacht with some nabobs
and celebrities among your friends), with a chocolate chip cookie
in
your right hand.

Surges a wave a little rougher than others.
Aaargh, your cookie falls and gets lost at sea!


This spoils your day.
Now you are in a bad mood, throw a tantrum, stamp your feet,
make the ship roll.

Then comes a caring steward, whose great-grand-mother
survived the Titanic.
He puts three chocolate chip cookies in your left hand, to offset
your pain.
Again, you are happy, a three cookies bonus was the sentimental
value
you attributed to the lost cookie.
Of course; if you prefer onion rings, herring fillets or whatever other
delicacy to cookies, please adapt the parable to your own taste.

The economic implications

When losses break our heart and freeze our mind.

Loss aversion and utility

In economic terms the prospect theory states that
A loss can be offset emotionally
only by a much bigger gain

It is a quite irrational but quite common attitude.
In general it is needed to gain about
euro euro euro 3 euros to compensate mentally a loss of 
euro 1 euro .
Theoreticians would say that the disitutility of losing one euro
offsets the
economic utility of gaining three euros
That theory explains the loss aversion
(not to be confused with Bernoulli's risk aversion seen above),
a notion that the investment case below helps to understand.

It has consequences in economic and
financial decision decision making,

The case of investment

Those effect are particularly salient in investor behaviors.
Investors are often reluctant to get rid of a security / asset on
which they are
poor losing money (*).

There is a paradox here, as the falling price is a signal that something
went wrong with that asset, and it would normally incite them to divert
their money into something safer or with better ...prospects.
But no, they cling to the lame duck!

(*) In comparison with the price the investor has paid to buy it, or
      with a reference price the investor had "
anchored" in his / her mind

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M.a.j. / updated : 13 July 2015
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