Unfairly Labeled Risk-Averse
A common way to say that humans are risk averse is the following experiment:
Which of these options do you choose?
- 100% chance of a million dollars.
- 40% chance of 5 million dollars.
Most people choose option #1. However, the EV (value of outcome * chance of it happening) of option #2 is better. $5M * 40% = $2M.
In other words, say you could run this experiment 100 times. If you chose option #1 each time, you’d have $100M. If you always chose option #2, you would have somewhere near $200M.
The author then uses this as evidence that humans are risk averse and emotional.
Value of money doesn’t scale linearly
Most people want the sure, $1M option because it’s a better deal! That is because the value of money doesn’t scale linearly with the respect of the net worth of the person.
The value of that first million is far more than the additional $4M in option #2. Especially the poorer you are.
Imagine you are born in a 3rd world country. You have 6 siblings. Your mother walks 5 miles every day to get clean water, then 5 miles back. There are no schools. Your father has a benign but growing tumor in his mouth, and your family can’t afford to fix it.
Is option #2 a better deal? Of course not!
You take that $1M right away because you can make 96% of the same life-altering changes with $1M as you can with $5M.
On the other hand, if you are a billionaire, you are much more likely to take option #2.