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Behavioral Odds

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“If you are the only one she has, make sure you are one in a million” – Irish Folk Song

Say you had an opportunity to buy one of fifteen lottery tickets to be sold to fifteen different individuals for $20 a ticket. Since this is a charity event, a corporate sponsor is kicking in coupons for $50 worth of free pizza at the local pizza joint. If your ticket ends up being the winning ticket you will claim the entire prize, which is worth $350. Would you spend $20 for a one-in-fifteen chance to win $350? That doesn’t sound too bad does it? Now say we change one thing. Instead of the 15 tickets being sold to 15 different people, the tickets are sold to only two people. You get to buy one ticket and another person, let’s call him Joe, buys the other 14. Joe-the-gambler has a 14 out of 15 chance of winning and you have a 1 out of 15 chance of winning. Would you spend the $20 now? Doesn’t sound as attractive does it? But your chances of winning under these two scenarios are identical. You have a 1 out of 15 chance when there are 15 participants in the lottery and you have a 1 out of 15 chance when there are 2 participants in the lottery. But with Joe owning 14 of the 15 tickets the whole thing comes across as less attractive – less fair, you perceive the deck as being stacked against you. But it is not stacked any higher in the second scenario than it was in the first scenario.

Traditional economic theory regarding how people make decisions assumes that they are completely rationale, or what is called perfect rationality, and would say that the likelihood of you purchasing your lottery ticket under the two differing scenarios would be identical, yet it is pretty easy to demonstrate in the real world that it is just not the case. Behavioral economics tries to take into consideration the psychology behind how people make decisions, decisions that might fly in the face of traditional economic equations.

The situation where the two starting positions can be mathematically shown to be equal but one psychologically appears to be disadvantageous is driven by what is called situational efficacy. You are less likely to buy the lottery ticket under the second scenario because of a perceived situational deficit. In a sports comparison, it is the equivalent of being the visiting team. Visiting teams often labor the assumption that there is a home team advantage. But it is still the same players, playing the same game that they have repeatedly practiced. But statistically you can demonstrate a home field advantage for the home team. It is coming from the player’s psychology or situation efficacy driven by the belief of a home team advantage and by the visiting team letting the situation (noisy crowds, unfamiliar physical location etc.) affect them.

About a year or so ago I saw the following demonstration in a room of about 1000 people. The speaker at the front of the room asked, “Please raise your hand if you are personally fighting cancer right now”. Five or six hands went up. Then he asked, “Please raise your hand if sometime in the past you had battled any form of cancer”. A larger number of hands were raised. Then he asked “Please raise your hand if someone in your immediately family is battling or has battled cancer”. Predictably, an even greater number of hands were raised. Then, “Raise your hand if any relative of yours has battled cancer”, then, “Now raise your hand if anyone you personally know has battled cancer”. He did not have to go that far to make his point. By the time he got to the relatives every hand in the room was raised. The demonstration pointed out two things. One, we are all interconnected and share common experiences to a much greater extent than we usually realize and two, well let me first ask the 1000 people reading this, “How many of you who do not currently have cancer or are unaffected by cancer in your immediate family, think you will be diagnosed with cancer this coming year? Please raise your hand if you believe that to be the case”.  Hard to see through the screen, but I don’t see too many hands raised. Even with our shared experience, even though we can see something like cancer all around us, sometimes we 1). choose not to see and 2). assume that things like cancer will happen to someone else. Not to us. Our brains are wired to assume that positive things will happen to us, at least the majority of us. Negative things happen to someone else; we hope for and desire positive things to happen to us. Assuming positive outcomes is an evolutionarily derived survival mechanism which allows us to forebear in the face of adversity. We are attracted to buying that lottery ticket when we think that each individual has an equal chance of winning or losing, because we perceive that given an equal chance as everyone else that positive things could happen to us, but when we perceive the deck being stacked, even if your own chances don’t change with the changing situation, the situation becomes less attractive to you.

If we take those notions and apply them to the mortgage meltdown, why would someone take out an ARM, an adjustable rate mortgage, knowing that they will not be able to pay the mortgage if the rate goes up, as it would do once any teaser rates expire or as the economic conditions change, and their income does not increase. Would they take that ARM if the bank were required to layout for them what their monthly payments will be once the teaser expires, and if the rate raised to the maximum amount possible each year, the worst case scenario being very clearly laid out for them? Providing knowledge can have a dampening effort on the desire to gamble.

Why would an organization merge with another, knowing that the only way the joint organization could survive is if the entire entity is restructured, with new unknown ways found to reengineer business processes to achieve greater efficiencies while maintaining phenomenal growth rates for an extended period of time?

Why would the federal government develop an annual budget that is dependent on assumptions about taxes, growth rates, and other sources of revenue while incorporating assumptions about expenses, all of which are simply unrealistic?

Why would children at school assume that they can get a good grade if they do not put in the necessary effort in order to do so, and then be disappointed when the grade does not come through?

I want to be careful here to delineate what I am describing from complete risk aversion. Humans can and will rise to new heights when faced with new and unexpected challenges. We can and do need to take risks in order to further ourselves individually and where we sit as a species. We are nothing else if not adaptable and resourceful. We need to be willing to reward people who try new things and fail, so that they are willing to try other things that might succeed, perhaps wildly. But the above descriptions are based upon irrational assumptions, not thoughtful processes. Saying that, we are also a product of our evolution and it would be erroneous to assume that simply because someone points out particular behavioral flaws that are inherent to our psychology, that the psychology can and will change. However, knowledge of why certain behaviors occur is the first step towards controlling and directing those behaviors.

Anyone want to buy a lottery ticket?

© 2010 by Jeffrey M. Saltzman. All rights reserved.

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Written by Jeffrey M. Saltzman

October 21, 2009 at 12:38 pm

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